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Finance: Capital Asset Pricing Model, Risk, Credit Policy

1. The Capital Asset Pricing Model rests on three assumptions. What are those assumptions, and how realistic are they for firms operating in competitive markets?

2. Leverage increases the risk of the equity of a firm. What does that mean, and what does that mean for the value of the stock in a firm?

3. Options are the right or obligation to sell or buy some asset. In the context of financial options, options represent a right in an underlying asset. Describe call and put options, and explain why someone would want to deal in options rather than in the underlying asset.

4. Firms that are leveraged face a funding risk. What does "funding risk" mean to a firm that is leveraged?

5. How does a company determine its credit policy?

6. Sification is supposed to reduce risks, but the diversification that can result when a merger occurs can sometimes be unwelcomed by stockholders in the acquiring firm. Why would stockholders in the acquiring firm not be interested in the diversification that results from a merger?

Solution Preview

The three main assumptions on which the capital asset pricing model (CAPM) rests are as below:
-The securities could be sold and bought by investors at competitive market prices and the can borrow and land at risk free rate
-Investors mostly hold the efficient portfolio with maximum expected return at a given level of volatility
-All investors have the same estimations and expectations (Homogeneous expectations) related to future investment and returns (Elton, Gruber, Brown & Goetzmann, 2009)

These assumptions are quite realistic as most of the investors seek for higher return on their investment with a less amount of risk. At the same time, at a given conditions the expectations for risk, volatility and return are also same. But at the same time, first assumption is not true as it is not possible for all investors to land/borrow at the same risk free rate. It is because the solvency position of the investor matters to get this position (Pahl, 2009). But at some extent, these assumptions are helpful for the firms to tell the behaviour of the investors that can be beneficial for the firm to increase its significance in the competitive markets.

Leverage means the portion of debt in the capital structure of an organization. An increase in leverage means an increase in the total portion of debt. An increase in the financial leverage increases the beta of equity in the firm, which exhibits the increase in risk for equity of the firm. It is because an increase in the debt portion in total capital structure causes an increase in the fixed interest payment of the firm, which causes a decline in the return for equity holders (Damodaran, 2010). Higher debt causes a variance in the earnings per share that makes the investment in equity more risky for the investors.

The value of stock in a firm means the market value of the stock of a firm or the firm's market capitalization. The stock value is generally presented by the market price of stock of the firm. An increase in debt capital also has significant influence over the value of the stock of the firm. As increase in leverage makes the risk for equity, the stock price of the firm ...

Solution Summary

The expert examines capital asset pricing models, risks and credit policies.