Midterm Review Questions

Foundations of Corporate Finance

1 Key Concepts
What is the shareholders’ objective? Pro…t maximization? or Wealth maximization? What is the
di¤erence?
Preferred shareholders receive preferred share dividends. Are these payments …xed or variable?
Common shareholders receive common share dividends. Are these payments …xed or variable?
Bonds versus Stocks: Which instrument is riskier? Which instrument yields more return? Hint: More
return implies more risk as investor would require more return to compensate themselves for the high
risk taken.
The expected rate of return on a …nancial asset could be computed in several ways depending on
the model used and the data availability. In particular, we learned the following ways to compute the
expected rate of return.

1. Sample average, r; if the analyst has historical data on the asset.

2. population average, , if the analyst made predictions about the states in the economy and their
corresponding probabilities (Recall: the two-periods model)
3. It could also be calculated as the expected rate of return on a similar asset in the same risk class.
4. Using CAPM: If the analyst believes in the axioms of CAPM.
5. Gordon Model: If the analyst believes in the axioms of this model.

CAPM is an equilibrium risk-reward model. This equilibrium is represented graphically by a line called
the SML. What is the slope of this line? What is the intercept of this line? What makes this line
steeper or ‡atter?
CAPM axioms and implications: Perfect information (Axiom 3) + investors’ rationality (Axiom 2)
imply what?
CAPM axioms and implications: Borrowing equal lending (Axiom 5) implies what?
CAPM and market e¢ ciency: Perfect information (Axiom 3) + investors’ rationality (Axiom 2) are
equivalent to the EMH.
What do we mean by diversi…cation?
What do we mean by risk of an asset? There are many types of risks: We covered two: Systematic risk,
, and total risk (or total volatility), denoted by :
= 0:4 means what?
= 0:4 means what?
Risk in CAPM is the beta coe¢ cient. It is systematic risk and it is non-diversi…able.
Total volatility is total risk of an asset. It includes both systematic and non-systematic risks.

------------- (non-diversifable)
Systematic risks are diversi…able.
What is the Sharpe ratio? It is the market excess return over the market volatility. It is the general
price of risk pertaining to a particular market.
Does the Sharpe ratio di¤er from one asset to another in a particular market M?
What is the alpha of a portfolio?

1
 When alpha has to be zero?

Risk aversion: What does it mean?

4Er
How to measure the degree of risk aversion? Hint: The marginal expected return per unit of risk, 4 :
Does this measure the degree or the type?
What is the bond pricing rule?

What do we mean by speculation?

What do we mean by consumption smoothing?

2 True or False - Review Questions

In each of the following statements, identify whether or not each statement is true or false and write a brief
explanation (one-two line at most) to support your argument. All credits will be given to the explanations.

1. GDP ‡uctuations in an economy is considered a non-systematic risk that is re‡ected in the total
volatility of …nancial assets.
2. The assumptions of rationality and perfect informations in CAPM imply that …nancial markets are
e¢ cient.

3. The e¢ cient markets hypothesis means that at any point time the demand must be equal to the supply
of …nancial assets.
4. If the beta coe¢ cient of an asset is zero, then the asset is free from non-systematic risk.
5. Preferred shareholders are considered …rst claimants whereas common stock holders are residual claimants.

6. The relationship between the coupon rate and the bond price is always negative.
7. The present value of a perpetuity is simply the …xed payment divided by the discount rate. Thus, one
can argue that it does not take into account all future payments.
8. The yield to maturity is preferred to the rate of return since it takes into account the time value of
money.
9. The covariance between the rates of return on two stocks is a measure of correlation between them.
10. A beta coe¢ cient of 1.5 means that the risk contribution of this asset in the market is 150%.
11. If the sigma of an asset is 2, then this asset is said to have a total volatility of 2%.