Question

Please help! Finance question on EFFICIENTLY INEFFICIENT(concept question)

Question background:

Suppose that you are considering buying a home, which you expect to live in for about 5 years, and, given the mobile workforce in Hong Kong, you also expect future buyers of the property to move relatively frequently. You find a house and an apartment which are equally attractive and consider which one to buy. (The house and apartment are equally attractive in the sense, for instance, that something similar could be rented at the same rates.)

Q3. Market liquidity. Suppose that the house is much more expensive to trade in terms of fees to the real estate agent, a longer expected waiting time when the property is on the market (and you may already have moved), and other costs. What would you pay more for, the house or the apartment? Explain your answer.

Q4. Funding liquidity. Suppose that the house and apartment are equally easy and costly to trade (have equal market liquidity), but the bank will give you (and future potential buyers) a larger loan for the apartment. Would that lead you to be willing to pay more for the apartment than the house? What would Modigliani-Miller say and why? Why might your answer be different?

Q5. Liquidity spirals and liquidity risk.

• If the house can be expected to be more difficult to trade than the apartment, which property do you think the bank will be more willing to provide a large loan for?

• If the apartment is more easy to borrow against, which property do you think will be more easy to sell?

• If suddenly there are many more properties for sale in this area than available buyers, how could the market and funding liquidity evolve? Might the market for houses evolve differently than the market for apartments?

• How does this liquidity risk affect the price you want to pay for the house vs. the apartment?

• How does the answer change if you expect to live in the property for 40 years?

Answer 1

Answer 3: As per Market Liquidity concept, in a liquid market, as in this case, the trade-off is mild. selling quickly will not reduce the price much. Hence, the market liquidity for the apartment will be lesser. Higher costs deter trading and increase the holding periods. The person would have to pay more for the house than the apartment. A

Answer 4 Funding Liquidity: If larger loan is available for the apartment, that would ideally lead to more payment towards apartment. However, as per Modiglani & Miller Concept, the basic assumption lies that in perfect market, capital structure is irrelevant for financing operations. The basic proposition of M&M concept are as follows:

1) No taxes

2) No transaction costs

3) No Bankruptcy costs

4) Equivalence in borrowing costs

5) Market information symmetry

6) No effect of debt in company's earnings

However as per the M&M additional theory, taxes and borrowing costs are evident to stay. Hence, they modified their proposition and they commented that there are benefits to leverage within a capital structure until the optimal capital structure is reached. Hence as per MM II theory, as the proportion of debt in the capital structure increases, its Return on Equity (ROE) increases in linear fashion.Hence a greater proportion of debt increases the company's weighted cost of capital. Hence, larger loan will lead to a lesser cost of acquisition and payment towards the apartment will be less costlier than the house.

Answer 5: High costs deter trading and increases the holding period, in which case the bank will be willing to provide larger loan for the house.