Financial poster

In a perfect market, the value of the project depends only on the project, and not on you personally or on your cash position. This is often called the “separation of investments and financing decisions.” You could make investment choices based on the quality of the projects themselves, not based on how you would end up financing them. The NPV formula does not have an input for your identity or wealth—its only inputs are the project’s cash flows and the rate of return on alternative investments.
But if the borrowing and lending rates are not the same, then the value of the project depends An example. on your cash holdings. For example, assume that you can lend money (invest cash) at 3%, and borrow money (receive cash) at 7%. What is the present value of a project that invests $1,000 today and returns $1,050 next period?
• If you have $1,000 and your alternative is to invest your money in the bank, you will only get $1,030 from the bank. You should take this project to earn $20 more than you could earn from the bank.
• If you do not have the $1,000, you will have to borrow $1,000 from the bank to receive $1,050 from the project. But because you will have to pay the bank $1,070, you will lose $20 net. You should not take the project.
The proper project decision now depends on how much cash you have. The separation between your project choice and your financial position has broken down. Taking your current cash holdings into account when making investment choices of course makes capital budgeting decisions more difficult. In this example, it is fairly easy—but think about projects that have cash inflows and outflows in the future, and how decisions could interact with your own wealth positions in the future. Equally important, in imperfect markets, the project value is no longer unique, either. In our example, it could be anything between $19.42 ($1,050 discounted at 3%) and −$18.69 ($1,050 discounted at 7%).