ESSAY QUESTIONS

1. What are the advantages of using the SML approach to finding the cost of equity capital?
What are the disadvantages? What are the specific pieces of information needed to use
this method? Are all of these variables observable, or do they need to be estimated? What
are some of the ways in which you could get these estimates?
Advantages of SML Approach to Cost of Equity Capital
 Provides a systematic and logical framework for estimating the cost of equity.
 Incorporates the relationship between risk and return, reflecting the market's expectations.
 Utilizes beta as a measure of systematic risk, allowing for a more precise estimation.
Disadvantages of SML Approach
 Relies on the accuracy of beta, which can be sensitive to the time period and the choice of
comparable companies.
 Assumes a linear relationship between risk and return, which may not always hold true in real-
world scenarios.
 Market efficiency assumptions may not always align with actual market conditions.
Information Needed for SML Method
 Risk-free rate of return (e.g., government bond yield).
 Market rate of return (e.g., historical stock market returns).
 Beta coefficient of the stock.
Observability of Variables
 Risk-free rate and market return are observable.
 Beta may need to be estimated, as it represents the stock's sensitivity to market movements.
Ways to Obtain Estimates
 Historical stock price data and market index returns can be used to calculate beta.
 Regression analysis can also be employed to estimate beta based on historical stock returns
and market returns.
By utilizing historical data and statistical methods, analysts can estimate the required
variables for the SML approach, enabling the calculation of the cost of equity capital.

2. Explain what is meant by business and financial risk. Suppose Firm A has greater
business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital?
Explain.
Business risk and financial risk are two fundamental concepts in finance and
investing. They represent different types of potential losses or adverse effects that a
business may face.
Business Risk
Business risk refers to the risk associated with the operations of a business. It is the risk
that a company will have lower than anticipated profits, or that it will experience a loss
rather than making a profit. Business risk is influenced by numerous factors, including:
 Sales volume
 Per-unit price
 Input costs
 Competition
 Overall market conditions
Financial Risk
Financial risk, on the other hand, is associated with the way a company finances its
operations. It refers to the risk that a company will not be able to meet its financial
obligations. Financial risk increases with the amount of debt a company has in its capital
structure because the company has to make regular payments on the debt.
Risk Type Definition Influencing Factors

Business Risk associated with the operations Sales volume, Per-unit price, Input costs,
Risk of a business Competition, Market conditions

Financial Risk associated with the way a Amount of debt in the company's capital
Risk company finances its operations structure

Business Risk and Cost of Equity Capital

The cost of equity capital refers to the return a company requires to decide on an
investment or project. It is the compensation to the shareholders for taking on the risk of
investing in the company.
If Firm A has a higher business risk than Firm B, it does not necessarily mean that Firm
A also has a higher cost of equity capital. The cost of equity capital is influenced by
several factors, including the risk-free rate, the market risk premium, and the company's
beta (a measure of its risk relative to the market). While a higher business risk could
lead to a higher beta and thus a higher cost of equity, other factors could offset this. For
example, if Firm A has a more stable cash flow or a more diversified business, it could
have a lower cost of equity despite its higher business risk.
 3. Explain 1) the factors that determine a security’s beta and 2) how asset beta relates to
equity beta.
Beta describes the activity of a security's returns responding to swings in
the market. A security's beta is calculated by dividing the product of the
covariance of the security's returns and the market's returns by the
variance of the market's returns over a specified period. Beta is useful in
determining a security's short-term risk, beta relies on historical data, it
doesn't factor in any new information on the market, stock or portfolio for
which it's used. Factors that determine a security’s beta are: 1) The
nature of business 2) The operating leverages 3) The financial leverages
Asset beta relates to Equity beta The asset beta (unlevered beta) is the
beta of a company on the assumption that the company uses only equity
financing. In contrast, the equity beta (levered beta, project beta) takes
into account different levels of the company's debt. A company has one
asset beta and, depending on its debt-to-equity ratio, it can have many
different equity betas. Asset Beta measures how volatile the underlying
business is without considering capital structure. You calculate asset beta
by removing the capital structure impact on the equity beta. Asset beta is
also frequently refered to as unlevered beta . This is important as it allows
investors to find an optimal capital structure by finding the average asset
beta of industry and then taking the average asset beta of the industry
and then "re-levering" it with the target company's capital structure with
the following equation. This beta allows investors to compare the relative
volatility of assets stripping out the effect of capital structure choices
FormulaβA=βE/1+(1−t)×DE β A – asset beta, β E – equity beta, D – market
value of debt, E – market value of equity t – marginal tax rate
4. In order to calulate the firm’s overal cost of capital (RWACC), should book value or
market value weight should be used? Explain.
Target weights should be used because target weights are the optimal mix of capital
structure( mix of debt, preferred stock, and common equity) that a company plans to use to
raise funds for it's future projects.

5. Why should a financial decision maker such as a corporate treasurer or CFO be

concerned with market efficiency?

As a financial decision maker, a corporate treasurer or CFO has the

responsibility of managing the company's finances and ensuring that the
company maximizes its profits. In order to make informed decisions, they
need to have an understanding of the market efficiency.

Market efficiency refers to the degree to which the market reflects all
available information in the stock prices. This means that if a stock is
undervalued or overvalued, the market will adjust the price to reflect the
true value of the stock. For a financial decision maker, this is crucial
because it helps them make informed decisions about investing in the
 stock market.
If the market is inefficient, it means that there is an opportunity to make
profits by buying undervalued stocks and selling them when the price
goes up. However, this also means that there is a risk of losing money if
the market does not correct itself. By understanding market efficiency,
financial decision makers can make informed decisions about investing in
the stock market and managing the company's finances.
Additionally, market efficiency also impacts the cost of capital for the
company. If the market is efficient, it means that the cost of capital is
accurately reflected in the stock price, making it easier for the company to
raise funds. On the other hand, if the market is inefficient, it may be more
difficult for the company to raise funds at a reasonable cost.
In conclusion, financial decision makers such as corporate treasurers and
CFOs should be concerned with market efficiency because it impacts their
ability to make informed investment decisions and manage the company's
finances effectively.
for more such questions on financial .
 6. Suppose your cousin invests in the stock market and doubles her money in a single year
while the market, on average, earned a return of only about 15 percent. Is your cousin's
performance a violation of market efficiency?
No, market efficiency does not preclude investors from 'beating the market' or preclude a firm
from doubling its value. It is entirely possible to earn higher returns than the market especially if
you accept additional risk. However, if your cousin is able to consistently double her money year
after year, then there would certainly be some doubt cast upon market efficiency.
7. Explain why in an efficient market all investments have an expected NPV of zero.
(1): In an efficient market all investments have an expected NPV of zero
because information is impounded in prices and hence investors will be
expected to earn a normal rate of return. It should be noted an efficient market
is one in which investors will be expected to earn only a rate of return that will
be just enough to compensate for the risk borne by the investor. The difference
between actual price and expected price will also be zero. (2): Yes, your cousin’s
performance is a violation of market efficiency. This is because market
efficiency is earmarked by the degree to which market prices reflect all
available, relevant information. In other words if the market is efficient then all
information is (and should be) incorporated into stock prices and so beating the
market is not possible. As current prices reflect all available and relevant
information the possibility of beating the market does not exist in an efficient
market. (3): The risk that often accompanies the behavioral concept of
familiarity is the risk of building a sub-optimal portfolio and the risk of ignoring
other viable options that can be added to portfolio diversification. It should be
noted that familiarity bias can occur when an investor has a preference for a
familiar investment. This is despite the fact that there are other viable
investment options available
8. Define the three forms of market efficiency.
Three Forms of EMH

 Weak form of efficient market

 Strong form of efficient market

 Semi-strong form of efficient market

1. Weak Form of Efficient Market

The current prices of the security reflect all security market.

Information including the historical prices, the rates of return,
traditional volume data and other market generated data. This
implies that the past rates of return should have no relationship with
future rates of return. In weak form of efficient market above
average return is earned.

The weak form of efficient market hypothesis says that you cannot
predict future stock prices on the basis of past stock prices. Weak-
form EMH is a shot aimed directly at technical analysis. If past stock
prices don’t help to predict future prices, there’s no point in looking
at them — no point in trying to discern patterns in stock charts.
2. Semi-Strong Form of Efficient Market

When the current security prices reflect all the public information
including market and non-market information. This implies that
decisions made on new information after it is made public with not
result into any above the average profit. In semi strong form of
efficient market no return is earned above average.

The semi-strong form of EMH says that you cannot use any
published information to predict future prices. Semi-strong EMH is a
shot aimed at fundamental analysis. If all published information is
already reflected in a stock’s price, then there’s nothing to be
gained from looking at financial statements or from paying
somebody (i.e., a fund manager) to do that for you.

Related Topic: Tests for the Semi Strong Market - Time Series
Test & Event Test
3. Strong Form of Efficient Market

The stock prices should reflect all the public and private information.
This implies that no group of investor should be able to earn above
average return consistently. This also implies that the transaction
costs are minimum.

The strong form of EMH says that everything that is knowable —

even unpublished information — has already been reflected in
present prices. The implication here would be that even if you have
some inside information and could legally trade based upon it, you
would gain nothing by doing so.
9. Identify the general rights that are commonly granted to common stock shareholders.
Common shareholders are granted six rights: voting power,
ownership, the right to transfer ownership, a claim to dividends,
the right to inspect corporate documents, and the right to sue for
wrongful acts.
10. Explain the main differences between debt and equity.
11. Describe some of the sources of business risk and financial risk. Do financial decision
makers have the ability to "trade off" one type of risk for the other?
12. 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?
13. 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.

14. False. A reduction

in leverage will
decrease both the risk
of the stock and its
15. expected return.
Modigliani and Miller
state that, in the
absence of taxes,
these
16. two effects exactly
cancel each other out
and leave the price of
the stock and the
17. overall value of the
firm unchanged
18. False. A reduction
in leverage will
decrease both the risk
of the stock and its
19. expected return.
Modigliani and Miller
state that, in the
absence of taxes,
these
20. two effects exactly
cancel each other out
and leave the price of
the stock and the
21. overall value of the
firm unchanged
22. False. A reduction
in leverage will
decrease both the risk
of the stock and its
23. expected return.
Modigliani and Miller
state that, in the
absence of taxes,
these
24. two effects exactly
cancel each other out
and leave the price of
the stock and the
25. overall value of the
firm unchanged
False. A reduction in leverage will decrease both the risk of the stock and its expected return.
Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel
each other out and leave the price of the stock and the overall value of the firm unchanged
26. 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.
27. Is there an easily quantifiable debt-equity ratio that will maximize the value of a firm?
Why or why not?
NO. Debt to equity ratio would indicate how the business structures
its sources of capital. Alternatively, this ratio shows us how the firm
is financing its operation.
28. What is the pecking order theory and what are the implications that arise from this
theory?
The pecking order theory states that companies prioritize their
sources of financing (from internal financing to equity) and
consider equity financing as a last resort. Internal funds are used
first, and when they are depleted, debt is issued. When it is not
prudent to issue more debt, equity is issued.
29. The Direct Interactive Publishing Company is planning to raise $200 million dollars in
new capital. There are currently 50 million shares outstanding with an estimated market
price of $60 each. The corporate officers are debating whether to use a rights offering
(with or without a standby underwriting) or have the issue fully underwritten. The
company is currently listed on a regional exchange and plans to list on a national
exchange after the security issue. List and explain three advantages/disadvantages of each
issue method.
30. Discuss the stages of venture capital financing, defining each in detail.
31. Suppose you look in the newspaper and see ABC trading at $50 per share. Calls on ABC
with one month to expiration and an exercise price of $45 are trading at $6.50 each. Puts
on ABC with one month to expiration and an exercise price of $55 are trading at $3.50
each. Are these prices reasonable? Explain. (Ignore transactions costs.)
32. Suppose XYZ is priced at $125 a share. The 150 call has six months to expiration and is
quoted at $.05. Why do you suppose investors would be willing to purchase a call that is
so far out of the money?
33. Explain the rationale behind the statement that equity is a call option on the firm's assets.
When would a shareholder allow the call to expire?
Here's an explanation of the rationale behind this idea:
1. Limited Liability: When you own equity in a firm, such as shares of
stock, you have limited liability. This means that your potential losses
are limited to the amount you have invested. Just like purchasing a call
option, your risk is limited to the premium paid for the option.
2. Upside Potential: Owning equity provides you with the opportunity to
benefit from the upside potential of the firm's assets. As the value of the
firm's assets increases, the value of the equity also increases. Similarly,
when you hold a call option, you can profit from an increase in the
underlying asset's price.
3. Expiration: A call option has an expiration date, after which it
becomes worthless if it is out of the money. Similarly, equity ownership
is ongoing, and as long as the firm continues to generate value, the
equity retains its value.
4. Exercise Price: The exercise price of a call option represents the
price at which the underlying asset can be bought. In the case of equity,
the purchase price is the initial investment made to acquire the shares.
5. Leverage: Just like a call option allows you to control a larger position
in the underlying asset with a smaller upfront investment, owning equity
allows you to have a proportional ownership stake in the firm's assets
without directly owning the entire value of the assets.
However, it's important to note that the analogy of equity as a call option
is not perfect. Equity ownership also comes with certain rights and
responsibilities, such as voting rights and potential dividend payments,
which are not inherent to call options. Additionally, equity ownership
involves a long-term commitment to the firm, whereas call options have
a finite expiration date.
34. Restrictive short-term financial policies regarding current asset management include
three basic actions. List and briefly describe each action.
The three basic areas are:- capital budgeting: the identification of investment
opportunities that have apositive net value- capital structure: the mix of long-term debt
and equity used to finance a firm's operations- working capital management: the daily
control of a firm's short-term assets and short-term liabilitie
35. In working capital management, there are some actions that increase cash. What are
some of the items that increase the cash account, respectively?
36. There are a number of ways firms can deal with financial distress. Identify at least 5 of
these.
37. Financial distress may benefit firms if it prompts them to "restructure their assets".
Explain what this means and how it can be beneficial.