Market Imperfections

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Market depths, Taxes, Transaction costs, and Opinions/ information

Coming aside from the other chapters, we have considered all our explanations based on ‘perfect market.’ As per that, there are no different explanations, taxes, transactions or even large markets with many buyers and sellers. We do follow the framework of a perfect market, covering issues like CAPM, risk, and even uncertainty. On a closer look, you will find that the formulations related to finance do depend on perfect markets assumptions. If it is not these assumptions, then these formulas may not help to give the correct outcome.

Now the most important question in this context is why such assumption for the perfect market so essential are? There are various reasons for which the importance of these assumptions is taken into consideration. As per this, we get an appropriate and unique expected return rate. This is applicable in both the cases. It may be for lending money on a project that is undertaken by someone. Or it may be to borrow funds to utilise on a project that you plan to run or are running.

Again if these assumptions are broken, then the models may have some serious issues. One of the major issues that you may face without any exclusive expected retune rate is no distinctive project prices.This in addition will solely rely on owner’s cash position. So, you can clearly understand that the term ‘value’ will not be important in this context.

However, assumptions related to perfect market are good to understand. But it is only in case of theoretical aspect. In the real world, such markets have no existence. Even if they are conceptual details, their information is closer to financial market.

Now to understand financial market in the real world, you need to leave the theory behind and follow the explanation of ‘imperfect world.’ One of the best things is NPV tool that is applicable to both imperfect and perfect world. But it is also important to remember that this tool has some limitations and has to be used with extra caution.

 

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