What does the Conservation of Value Principle state about financial transactions in perfect capital markets?

The Conservation of Value Principle is fundamental in corporate finance, particularly in the context of perfect capital markets. It asserts that financial transactions do not create or destroy value; instead, they merely rearrange risk among different parties without altering the overall value of the assets involved.

In perfect capital markets, the assumptions include no taxes, no transaction costs, and symmetrical information among all participants. Under these conditions, any financial transaction that takes place, such as issuing debt or equity, repositions the risk exposure for investors but does not impact the total value of a firm. For instance, if a company decides to leverage itself by taking on debt, it changes its capital structure and the risk profile of its equity. However, the total value of the firm remains unchanged because the overall returns, risks, and cash flows of the investments do not change—they simply change hands in terms of who bears the risk and who receives the returns.

This principle helps to clarify that the market value of securities is determined by their expected future cash flows rather than the way they are financed. The correct answer, therefore, accurately captures this essence of the Conservation of Value Principle, highlighting that financial transactions in perfect capital markets serve to reconfigure risk among investors rather than increase or decrease value.