Class 23

Question 1

Perfect markets elements

Answer 1

• info is freely available and its all we need (assumer rationality)
• large # of sellers
• large # of buyers
• homogenous goods

Question 2

firm value =

Answer 2

present value of expected cash flows:

E(Net Cash Flow)/ (1+r)^t

Question 3

how is firm value determined?

Answer 3

• expected cash flows (earnings)

- required rate of return

Question 4

cash flows =

Answer 4

earnings

Question 5

required rate of return =

Answer 5

expected return could earn on the next best investment (Affected by time and risk)

Question 6

time effect

Answer 6

• preference for cash (to make investments) today rather than in the future
• the longer the duration until payment, the lower the value today

Question 7

risk

Answer 7

individual preference for less risk rather than more risk; all else equal (what source of risk)

Question 8

speculative risk

Answer 8

can gain or lose

Question 9

pure risk

Answer 9

can only have a loss

Question 10

low frequency, high severity =

Answer 10

more risky

Question 11

assume that corporations (publicly traded firms) operate in…

Answer 11

perfect markets

Question 12

what is the objective for publicly traded firms?

Answer 12

to maximize shareholder wealth (i.e. maximize firm value)

Question 13

components of a firm’s total risk

Answer 13

• diversifiable (also called idiosyncratic or nonsystematic risk)
• non-diversifiable (also called market or systematic risk)

Question 14

diversifiable =

Answer 14

nonsystematic (or idiosyncratic); relatively independent observations

Question 15

non-diversifiable =

Answer 15

systematic; relatively positively correlated observations

Question 16

which type of risk is pooling effective for?

Answer 16

diversifiable risk (investors can pool it away in exactly the same way that insurers take advantage of pooling)

Question 17

RM for firms owned by well diversified investors can only increase firm value by…

Answer 17

increasing net cash flow because the risk in firm value calculation is only systematic risk, which is not diversifiable

Question 18

why do we observe corps. buying insurance and spending resources on RM?

Answer 18

they do not buy insurance for benefit of pooling (in a perfect market)

Question 19

ways to increase expected cash flows

Answer 19

• insurer sometimes offers desired services more efficiently, lowering costs
• costs associated with financial distress might be reduced
• raising new funds (capital) may be less costly
• tax payments may be delayed (and insurers can deduct reserves even though insureds cannot)

Question 20

raising new funds (Capital) may be less costly

Answer 20

• obtaining new funds thru issuing bonds, stocks, or getting a loan has costs
• using existing (internal) fund takes resources from productive investments (and has signaling effect)

Question 21

costs of issuing debt

Answer 21

• signaling costs
• sell shares costs
• having bank help
• cost of divulging share value
• to invest internal funds (not putting in some other use_

Question 22

30/70 Reinsurance agreement

Answer 22

Primary: pays 30%
Re: pays 70%

Question 23

what is the only risk that matters?

Answer 23

systematic risk