1.

According to the Capital Asset Pricing Model (CAPM), the expected return on a risky
asset depends on three components. Describe each component, and explain its role in
determining expected stock returns.

- The expected return on an asset is dependent on 3 components: Risk free rate, beta
and market risk premium.
+ Risk free rate: the pure time value of money.
+ Beta: amount of systematic risk appears in a particular asset.
+ Market risk premium: the reward for bearing systematic risk.

2. Explain in words what beta is and why it is important.

- Beta is a measure of systematic risk. Beta specifically measures the responsiveness of a

security to the movements in the market portfolio and is relevant for determining
expected return. Beta is the cornerstone of the CAPM. When comparing the difference in
expected return of 2 companies, look at their betas.

3. Sometimes it is not clear if a particular security is debt or equity. Explain the basic
difference between debt and equity.

Features Equity Dept

Income Dividends. Interest.

Tax status Taxed as personal income, although Taxed as personal income. BUT,
currently capped at 15%. Dividends are interest is a business expense and
not a business expense. corporation can deduct their interest
when computing corporate tax liability

Control Common stock has voting rights. Control is exercised with loan
agreement.

Default Cannot be forced into bankruptcy for Unpaid debt is a liability of the firm.
nonpayment of dividend. Nonpayment will lead to bankruptcy

4. In each of the theories of long term capital structure (with/without tax) the cost of
equity rises as the amount of debt increases. So why don't financial managers use as
little debt as possible to keep the cost of equity down? After all, isn't the goal of the firm
to maximize share value and minimize shareholder costs?

- The capital structure theory stated that: “The firm trades off higher equity cost for lower
debt cost. According to that, the shareholder will benefit because their investment in the
company is leveraged, enhancing the return on their investment. So, even when the cost
of equity rises, the overall cost of capital decreases and the firm value rises.
5. Why are some risks diversifiable and some nondiversifiable? Give an example of each.
- Some risks are diversifiable because they are unique to that asset and can be eliminated
by investing in different assets. When an investor diversifies his risk by investing in many
different assets, there is an unsystematic strategy that is executed that reduces the
overall risk.
Example: House fire, Tornado, Death
- Some risks are non diversifiable because the risk applies to all assets. When risks are
nondiversifiable, it is because of the systematic risks which affect the investments.
Therefore, you are unable to eliminate the total risk of an investment.
Example: Unemployment, Flood, Property damage from war

6. If a portfolio has a positive investment in every asset, can the expected return on the
portfolio be greater than that on every asset in the portfolio? Can it be less than that on
every asset in the portfolio? If you answer yes to one or both of these questions, give an
example to support your answer.
- The answer is no for both. The answer is no because the expected return of the portfolio
is a weighted average of the returns from its assets, so the expected return must be less
than the returns from the largest asset and greater than the returns from the smallest
asset.

7. Is the following statement true or false? Risky security cannot have an expected return
that is less than the risk-free rate because no risk-averse investor would be willing to
hold this asset in equilibrium. Explain.
- False. A security can have negative risk (i.e., βi < 0). Since this security has a negative
covariance with the market it is quite effective in reducing the risk of portfolios. For this
reason, people will be willing to accept an expected return that is less than RF.
The Sharpe-Lintner CAPM gives us:
E(Ri) = RF + [E(Rm) − RF]βi (where: E(Rm) − RF > 0.)
Therefore, βi < O implies that,

E(Ri) < RF

Even though Ri is uncertain.

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8. In a world with no taxes, no transaction costs, and no costs of financial distress, is the
following statement true, false, or uncertain? If a firm issues equity to repurchase some
of its debt (capital restructuring), the price per share of the firm’s stock will rise because
the shares are less risky. Explain.
- As per the M&M theory, issue of equity will reduce risk which in turn will reduce
the required rate of return by shareholders, that is, in the absence of taxes, these
two effects will exactly offset each other and leave the price per share value of
the firm unchanged. Therefore, the statement that the price per share will raise
as issue is less risky is false

9. In a world with no taxes, no transaction costs, and no costs of financial

distress, is the following statement true, false, or uncertain? Moderate borrowing
will not increase the required return on a firm’s equity. Explain.
- False. Required rate on a firm's equity is positively related to the firm's
debt-to-equity ratio [Rs = Ro + (B/S)(Ro -Rb)]. Therefore, any increase in the
amount of debt in a firm's capital structure will increase the required return on the
firm's equity.

10. Is there an easily identifiable debt–equity ratio that will maximize the value of
a firm? Why or why not?
- Because many relevant factors such as bankruptcy costs, tax asymmetries, and
agency costs cannot easily be identified or quantified, it's practically impossible to
determine the precise debt-equity ratio that maximizes the value of the firm.
However, if the firm's cost of new debt suddenly become much more expensive,
it's probably true that the firm is too highly leveraged

11. What are the key differences between leasing and borrowing? Are they perfect
substitutes?
- Lease payments are fully tax-deductible, but only the interest portion of the loan
is
 - The lessee does not own the asset and cannot depreciate it for tax purposes
- In the event of a default, the lessor cannot force bankruptcy
- The lessee does not obtain title to the asset at the end of the lease

12. Taxes are an important consideration in the leasing decision. Which is more
likely to lease: A profitable corporation in a high tax bracket or a less profitable
one in a low tax bracket? Why?
- The less profitable one because leasing provides a mechanism for transferring
tax benefits from entities that value them less to entities that value them more.

13. Shortage cost: occurs when customer demand cannot be met because of
insufficient inventory. If these shortages result in a permanent loss of sales, shortages
costs include the loss of profits
- Shortages occur because carrying inventory is very costly
- As the amount of inventory hand increases, the carrying costs increase whereas
shortage costs decrease
- Damage to reputation
- Lost sales

14. In an ideal economy, NWC = 0. Why might NWC be positive in a real economy?
- Long-term growth trends in sales require some permanent investment in current
assets. Which means in the real world, net working capital is not zero.
- NWC is unlikely to be zero as there is a variation across time for assets. Liquidity
reason.

15. Is it possible for a firm to have too much cash? Why would shareholders care
if a firm accumulates large amounts of cash?
- Yes. Once a firm has more cash than it needs for operations and planned
expenditures, the excess cash has an opportunity cost. It could be invested (by
shareholders) in potentially more profitable ways