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Assumptions of Ideal capital

market

1.Capital markets are


frictionless Market
participants face no transaction
costs or taxes. Investors face no
brokerage commissions or fees
on trades, and short selling is
restricted. Firms face no
transaction costs in issuing or
retiring securities, and there are
no costs associated with
bankruptcy.

2. All market participants share


homogenous expectations
value-relevant information
is costlessly available to all market
participants, and all participants
rationally process such information
to determine the value of any
security. Thus, all participants share
common expectations about the
prospects of investments

3. All market participants are


atomistic No single market
can affect the market price of a
security via trades.
4.The firms investment
program is fixed and known
The firms investment
program, and therefore its
assets, operations, and
strategies are fixed and known
to all investors.

5. The firms financing is fixed


once chosen, the firms capital
structure is fixed

The first three assumptions


establish the setting within which
securities trade. The last two
assumptions restrict the scope of
a firms investment and financing
decisions

Overall, the assumptions allow


certain activities by either a firm
or investors, but disallow other
activities.

The purpose of studying theory under


ideal conditions is twofold gaining insight into the effect of the firms
decision on the values and risk of its
securities(thus such decisions may yet
have the predicted effects even if real
world conditions are nearing the ideal)
In a better position to understand the
incremental effects of certain real world
factors(which may violate one or more of
the ideal market assumptions) after
understanding corporate financial
decisions under ideal conditions

Violations of ideal capital


market

Assumption I Frictionless
market
There are at least five consequences
of violations of this assumption
1. transaction cost and personal taxes
may affect investors ability to
undertake arbitrage, which is very
important for
MM theory
propositions, the CAPM model, the
Binomial Pricing Model, and the
BSOPM Model

2. variation in personal tax rates and


transaction costs across both investors and
securities may differentially affect the
values of corporate securities (e.g. debt vs.
equity), and ultimately a firms preference
for issuing one type of security vs. another
3. If a firms earnings are taxed, and interest
payments are deductible while dividends
are not(U.S), a firms preferences for debt
vs. equity financing may be determined in
part by the effect of taxes on the market
value of the firm.

4. If a firm faces transaction costs in


issuing securities, such frictions may
prevent its ability to undertake
profitable investment opportunities,
thus affecting choice of debt vs.
equity financing
5. Costs of financial distress and
bankruptcy, which are basically
transaction costs associated with
the presence of debt in a firms
capital structure, may create
problem in issuance of debt

Assumption II All market


participants share homogenous
expectations In real world
situation information asymmetry is
present between investors and the
firms management. The
management being insider has more
information than investor

Assumption III Atomistic


competition an investors wealth
to purchase security is small in
comparison to the total value of a
given firms securities
two important real world violations
may be there * If an investor has so much of
wealth to purchase a given firms
securities it will the reflect the
personal preferences of the dominant
investor

* firm may issue substantial securities and can


opt for repurchase of shares outstanding
both the type of transactions may effect the
market value of securities
On the other hand atomistic competition also
brings about principle agent conflict. The
investors themselves are so many that they
cannot personally monitor the firm. Therefore
they appoint a manager, who in turn pursues
his own interests.
Thus atomistic assumption needs to
be violated to avoid adverse effects of a real
world situation

Assumption IV - firms investment


program is fixed and known
If the firms debt is default risky the
management will change the capital
investment program in a manner to
benefit the shareholders and
resulting in expropriation of wealth
from the debt holders to the equity
holders. The firm must also keep
some strategic information secret,
known only to insiders.

Assumption V - The firms financing is


fixed A firm if initially finances its
debt with particular debt-equity
combination, may issue further debt to pay
dividend to the shareholders. If the later
debt has the same priority as the prior
debt then the prior debt holders suffer
expropriation of wealth from the
shareholders
(total of dividend and the market value
of the remaining equity will be greater
than the total value of the equity prior to
the issuance of new debt)