Week 1

Question 1

Capital budgeting rule:

Answer 1

The project’s expected return should be at least the expected return on assets with comparable risk, as investors would choose to invest in these other financial assets if the return is below.

Question 2

CAPM:

Answer 2

Re=Rf+Beta*(Rm-Rf)
Beta - company Beta

Question 3

Beta:

Answer 3

Refers to the riskiness of a security compared to the risk of the entire market portfolio. For every 1% increase in market the equity will increase by Beta %.

Beta = Cov(Ri, Rm)/Var(Rm)

Variance refers to how many values in a set deviate from the average.
Covariance measures the degree to which the two sets move in the same direction.

For projects, project-specific beta must be used if beta differs from corporation beta.

Question 4

Problems that occur when estimating beta:

Answer 4

1)Sample size can be inadequate.
2)Betas will be influenced by financial leverage and business risk.
3)The betas can vary over time.

Question 5

Solutions to problems with betas:

Answer 5

1)The use of more sophisticated statistical techniques
2)Incorporation of fluctuations
3)The use of industry betas (only when operations are alike)

Question 6

Influences of Beta:

Answer 6

1)Cyclicality of Revenues - higher beta for companies that highly vary in the business cycle and contraction cycle.
2)Operating Leverage - magnifies the effect of cyclicality as the fixed costs remain high even when low production.
3)Financial Leverage - fixed costs of financing (interest).

Question 7

Beta when the company has financial leverage:

Answer 7

Beta(A)=B(E)*(E/D+E) as we assume Beta(D)=0

Question 8

Reducing Cost of Capital:

Answer 8

Firms can increase liquidity. Liquidity refers to the costs of buying and selling shares. High trading costs lead to low levels of liquidity leading to high cost of capital.

Trading costs include:
1)Brokerage fees
2)The bid-ask spread
3)Market impact costs

Question 9

Adverse selection:

Answer 9

Adverse selection refers to when a counterparty is picked off based on information asymmetry. Traders with more information benefit from traders who possess less information.

Traders protect themselves by increasing prices or decreasing buying prices, resulting in a wider bid-ask spread, and hurting all investors.

Question 10

Two strategies that the company can follow to decrease the cost of capital:

Answer 10

1)Bringing in more uninformed investors. This can be achieved through stock splits, resulting in more affordable shares for an uninformed investor. Leading to lower adverse selection
2)Reduce information asymmetry - disclosing more information. Raising interest for analysts.

Question 10

International consideration for the cost of capital:

Answer 10

1) Initial public offering costs: underwriting fees, professional fees, listing fees, and price discounts.
2) Ongoing costs of maintaining a public listing: regulatory, corporate governance, and professional fees, annual listing fees, and trading costs.

Question 10

ROA:

Answer 10

ROA = After-tax earning/Investment or asset base

ROA>Cost of capital -> project should be accepted.
The higher ROA the better, but could lead to profitable projects being rejected, as it would decrease overall ROA. Leading to managers acting following ROA rather than profitability.

Question 11

Economic Value Added:

Answer 11

EVA=(ROA-WACC)*Total capital

Monetary value leads to a simple decision-making process. Positive EVA => accept, negative EVA => reject.

Problems with EVA:
1) Does not consider future cash flows
2) Can lead to short-sightedness if used as the sole determinant, this is also the problem of ROA.