Question
I got the following question on a test: You have just started working for a corporate finance firm. You are asked to value a company
I got the following question on a test:
You have just started working for a corporate finance firm. You are asked to value a company with both debt and equity in its capital structure. You are unsure how to best estimate the value and therefore seek advice from a colleague. The advice you get is to assume perfect capital markets at the start of the analysis. Explain why this is good advice by providing two examples using the assigned space in the text box below.
My answer:
If you take market imperfections into account from the start, you risk getting a positive NPV only because gains due to for example an increased tax shield. That investment could easily become a negative NPV investmest if there are changes to the tax code tomorrow so therefore assuming perfect markets to begin with gives a better idea of the underlying streanght of the investment. Another example is that by assuming perfect capital markets you can ignore bankruptcy- and agency costs which are hard to estimate and so you isolate these factors later on.
This was answer was not accepted. Can someone help me out by explaining the faults in my reasoning and maybe provide two better examples?
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