Evaluate the following statements.True/False/It Depends? Explain your answers briefly.

A] Under perfect capital markets, investor's choice between alternative income streams depends only on their net present values. 

B]Under imperfect capital markets, a person's time preference does not affect whether or not they invest in a business project

C] Consider two investors, A and B, where A is the more patient of the two (i.e., A's utility function puts greater weight on future consumption). Statement to evaluate: "If an interest rate increase makes B better off, it will necessarily also make A better off." 

 

A. TRUE

 Capital Market is perfect when any of the investors have enough power to change the price of an asset and all of them have access to the same information. Meaning, that there are lots of choices for them to choose from in the existing markets and their choices therein was made solely on the capacity of a firm to produce an income to them.

B. FALSE

Under an imperfect market, individual buyers and sellers can influence prices and production, there is no full disclosure of information about products and prices, and there are high barriers to entry or exit in the market. A perfect market is characterized by perfect competition, market equilibrium, and an unlimited number of buyers and sellers. Therefore a persons tome preference affects a business because they hold such power.

C. Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including current rate levels, expected future rate changes, consumer confidence, and the overall health of the economy. An increase in interest rates may lead consumers to increase savings since they can receive higher rates of return. This is outlined in the marginal propensity to save. Suppose you receive a $500 bonus with your paycheck. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase on a new business suit and save the remaining $100, your marginal propensity to save is 0.2 ($100 change in saving divided by $500 change in income). If this happens it will be advantageous for B and also automatically for A because A has a greater utility function.

Step-by-step explanation

A. Capital markets are said to be perfect if they satisfy three conditions:Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

1. There are no taxes, transaction costs, or issuance costs associated with security trading.
2. A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.

According to MM Proposition I, with perfect capital markets the value of a firm is independent of its capital structure. With perfect capital markets, homemade leverage is a perfect substitute for firm leverage. If otherwise identical firms with different capital structures have different values, the Law of One Price would be violated and an arbitrage opportunity would exist.

B. All real-world markets are imperfect. Thus, the study of real markets is always influenced by competition for market share, high barriers to entry and exit, different products and services, prices set by price makers rather than by supply and demand, imperfect or incomplete information about products and prices, and a small number of buyers and sellers.

For example, traders in the financial market do not possess perfect or even identical knowledge about financial products. The traders and assets in a financial market are not perfectly homogeneous. New information is not instantaneously transmitted, and there is a limited velocity of reactions.

C. The current level of rates and expectations regarding future rate trends are factors in deciding which way consumers lean. If, for example, rates fall from 6% to 5% and further rate declines are expected, consumers may hold off on financing major purchases until lower rates are available. If rates are already at very low levels, however, consumers will usually be influenced to spend more to take advantage of good financing terms.