Are Transaction Costs and Tax Effects Worth the Trouble in Valuation Theory?

Abstract

Most valuation theory has ignored transaction costs, has either ignored taxes or treated them ad hoc, and has used NPV to value riskless cash flows. Recently, in a new approach, transaction costs were explicitly considered, taxes were treated in more detail, and the single term structure vector of NPV was replaced by a convex multifaceted packet of term structure vectors. Accordingly, simple vector multiplication of cash flows by that single term structure vector was replaced by linear programming over this entire packet. But is the resulting complication worth the trouble? This paper shows that NPV can create substantial errors due to the difference between long and short positions. The biggest errors stem from ignoring short-borrowing costs and can be exacerbated by ignoring taxes. Actual market prices are used along with the transaction cost and tax schedules of major investors, including their four tax payment dates each year.