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 corner stone of the CAPM. When comparing the difference in expected
return of 2 companies, we look at their betas.

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 CAPM suggests that the expected return is a function of (1) the risk-free rate of
return, which is the pure time value of money, (2) the market risk premium, which is the
reward for bearing systematic risk, and (3) beta, which is the amount of systematic risk
present in a particular asset. Better answers will point out that both the pure time value of
money and the reward for bearing systematic risk are exogenously determined and can
change on a daily basis, while the amount of systematic risk for a particular asset is
determined by the firm’s decision-makers.

Explain homemade leverage and why it matters

Homemade leverage is used by an individual investor to artificially adjust the
leverage of a company. Mainly attributed to the Modigliani-Miller Theorem, homemade
leverage describes the situation where individuals borrowing on the exact same terms as large
firms can duplicate corporate leverage through purchasing and financing options.

Why are some risks diversifiable and some non-diversifiable? Give an example of each.
Some risks are diversifiable because they are unique to that asset and can be
eliminated by investing in different assests. When an investor diversifies his risk by investing
in many different assets, there is an unsysmtematic strategy that is executed that reduces the
overall risk.
On the other hand, some risks are nondiversifiable because the risk applies to all
assets. When risks are nondiversifiable, it is because of the systematic risks which affect the
investments. Example: bond, real estate, share/stock, etc.

Briefly explain how the use of single company cost of capital to evaluate projects might
lead toerroneous decisions.
If the firm is considering projects with differing risk characteristics, the firm will
reject lowrisk projects and accept high-risk projects. In reality low - risk projects should be
discounted at a lower rate and high-risk projects at a higher discount rate to account for
differing risks.
Explain the main differences between debt and equity.
Debt is the borrowed fund while Equity is owned fund. ... Debt can be in the form of
term loans, debentures, and bonds, but Equity can be in the form of shares and stock. Return
on debt is known as interest which is a charge against profit.

Briefly explain different types of voting used for the election of the board of directors.
Cumulative voting: the directors are elected all at once. The shareholder is
permittedto multiply the number of shares by the number of directorships being voted on and
dispose the votes as individual wishes. This method allows shareholders to cast all of their
votes for a single nominee for the board of directors => helps minority shareholders
strengthen the ability to be in the board of directors.
Straight voting: the directors are elected one at a time. Ad shareholder may only cast
one vote per share that the shareholder has. The only way to guarantee a seat is to own 50
percent plus one share.
Proxy voting: is a form of voting whereby a member of a decision-making body may
delegate his or her voting power to a representative, to enable a vote in absence. This usually
results in a proxy fight - the action of a group of shareholders joining forces in a bid to gather
enough shareholder proxies to win a corporate vote

Is there an easily identifiable debt–equity ratio that will maximize the value of a firm?
Why or why not?
The answer is 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. If
this ratio is significantly high, it means the company would not be able to pay back creditors
by its initial equity, which will lose its liquidity.

How does the existence of financial distress costs and agency costs affect Modigliani and
Miller’s theory in a world where corporations pay taxes?
Modigliani and Miller’stheory with corporate taxes indicates that, since there is a
positive taxadvantage of debt, the firm should maximize the amount of debt in its capital
structure.
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

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.

What are the costs of shortages of current assets? Describe them.

Shortage costs are the costs which decrease with the increase in the level of the
current assets. Shortage costs are of two kinds: trading or order costs and costs related to lack
of safety reserves.

In working capital management, there are some actions that increase or decrease cash.
What are some of the items that increase and decrease the cash account, respectively?
Activities That Increase Cash
· Increasing long-term debt (borrowing over the long term)
· Increasing equity (selling some stock)
· Increasing current liabilities (getting a 90-day loan)
· Decreasing current assets other than cash (selling some inventory for cash)
· Decreasing fixed assets (selling some property)
Activities That Decrease Cash
· Decreasing long-term debt (paying off a long-term debt)
· Decreasing equity (repurchasing some stock)
· Decreasing current liabilities (paying off a 90-day loan)
· Increasing current assets other than cash (buying some inventory for cash)
· Increasing fixed assets (buying some property)

What are venture capitalists and what is their role in raising capital for firms?
Venture capital firms obtain investment capital by pooling money from pension funds,
insurance companies, wealthy investors, and the like. The firm makes the decisions about
which businesses to invest in and receives management fees and a percentage of the profits as
compensation.
List the three advantages/disadvantages of rights issue method firms can use to raise
new capital.
Advantages of the Rights Issue of Shares
 The shares are offered to the shareholders at the discounted price to encourage them
to purchase the rights issue.
 The company saves a significant amount of money, such as underwriting fees,
advertisement cost and so on.
 The control of the company remains in the hands of the existing shareholders. This is
because the shares are only issued to those shareholders who on the date of rights
issue are the holders of the shares.
 There is an equitable distribution of the shares and the same proportion of the voting
rights.
Disadvantages of the Rights Issue of Shares
 The company may not be able to raise more funds and fail to achieve their target. This
may happen if the existing shareholders of the company are not too keen to invest
more.
 The value of each share may get diluted if there are an increased number of shares
issued.
 If a well-established company is going for the rights issue of the shares, then it goes
on to create a negative market sentiment. It is assumed that the company is struggling
to run its business operations smoothly.
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.
The statement is false. The MM theory proved that issue of equity will reduce risk. As
the risk reduces, the cost of equity capital reduces as a result which will reduce the required
return of the shareholders. In fact, MM proved that the two effects exactly offset each other,
so that both the value of the firm and the firm’s overall cost of capital are unchanged.

If a portfolio has a positive investment in every asset, can the standard deviation on the
portfolio be less than that on every asset in the portfolio? What about the portfolio
beta?
The answer is no for both 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.

Why do we use an after-tax figure for cost of debt but not for cost of equity?
Interest expense is tax-deductible. There is no difference between pretax and aftertax
equity costs
What are the different inventory types? How do the types differ? Why are some types
said to have dependent demand, whereas other types are said to have independent
demand?
Generally, inventory types can be grouped into 3 classifications: raw materials,
work-in-process and finished goods.The demand for an inventory item that becomes a part of
another item is usually termed derived or dependent demand because the firm’s need for
these inventory types depends on its need for finished items. For example, this would be the
microchips in the computer, the wheels on the bicycle, or the cheese on the pizza. In contrast,
independent demand is demand for products such as computer, bicycle or pizza.

What are some of the characteristics of a firm with a long operating cycle?
These are firms with relatively long inventory periods and/or relatively long
receivables periods. Thus, such firms tend to keep inventory on hand, and they allow
customers to purchase on credit and take a relatively long time to pay.