Define the Three Conditions That Make Up a Perfect Capital Market, and Then Compare and Contrast the Effects of Perfect Capital Markets and Imperfect Capital Markets on Value. Can They Create or Destroy Value? Explain.

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Modigliani and Miller stated that their propositions were true under a set of conditions referred to as perfect capital markets: 1. Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. 2. There are no taxes, transaction costs, or issuance costs associated with security trading. 3. A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them. If these key assumptions are relaxed, capital structure may become relevant to the firm’s value. In the real world, no investment market quite meets all of the required pre-conditions for a perfect capital market because there are evident asymmetries of size, access to capital, knowledge, experience and information, as well as transaction costs, taxes and other externalities. There are also many studies supporting the presence of a variety of motivations and behavioral influences behind investors activity. The assumption that investors are rational and therefore value investments rationally – that is, by calculating the net present values of future cash flows, appropriately discounted for risk – is not supported by the evidence. However, perfection may not be required, according to Eugene Fama (Fama, 1970, pp. 383–417) : Quote An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximizers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have

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