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Answers to Exam Questions - Essay Example

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1. The capital asset pricing model (CAPM) is one of the most popular tools in finance which is used to determine a theoretically required rate of return of an asset, if that asset is added to an already well diversified portfolio, given the asset's non-diversifiable risk (Capital Asset Pricing Model 2006)…
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Download file to see previous pages First, the model is simple and easy to understand as well as to implement. It should be noted that the variables in the formula can be easily accessed from public sources except the beta-coefficient which is not usually available for small and non-publicly traded business organizations. Secondly, it can be seen that the CAPM does not rely on dividends or have any assumptions on the growth of dividend which makes it applicable to companies that do not pay dividend or are not expected to experience a constant growth rate for dividends (Keown , et al. 2004).
However, the CAPM is also widely criticized because it does not adequately explain the variation in stock returns. Empirical studies including the work of Black, Jensen, and Scholes reveals that low beta stocks may offer higher returns than the model would predict. CAPM will not also work for individuals which are risk averse as it assumes that investors will generally favor a stock with higher returns even if holding it entails more risks. Also, it can be seen that CAPM doesn't take into account the associated transaction costs and taxes (Capital Asset Pricing Model 2006).
It should be noted that in using CAPM, companies with different debt leverage will generate different cost of capital even if they belong to the same industry. Debt leverage is reflected in the CAPM formula as the company's beta coefficient. Accordingly, higher debt leverage will yield to a higher as debt is seen a riskier source of financing.
Capital Asset Pricing Model 2006, Retrieved 14 October 2006, from
Keown, A., Martin, J., Petty, W., & Scott, D. 2004, Foundations of Finance, Upper Saddle River, New Jersey
McCracken, M. E. 2005, CAPM, Retrieved 14 October 2006, from
2. Debt leverage is the amplification of the return earned on equity when an investment or firm is financed partially through borrowed money (Walker n.d.). In order to illustrate how debt leverage works, let's look at a company who wants to buy a building as an investment which costs $1,000,000. In turn, it wishes to find customers who would want to rent the spaces. It expects to generate $15,000 per month. If the company has enough cash, it can immediately buy the building find tenants and can sell it at $1,200,000 after one year. Thus, the company will have a total gain of $380,000 from the sum of the rents and appreciation in the building's market value. This represents a 38% return on investment. However, if the company has only paid $200,000 and opted to borrow the remaining $800,000 with a mortgage rate of 12%, then the company will be paying $8,000 per month. Since interest payments are tax deductible, the company's monthly rent income of $15,000 will be more than enough to cover the expenses. Even taking only the $200,000 appreciation of the building, the company is already able to recoup 100% of its initial investment.
In the illustration above, we can see that debt leverage helps the company to maximize the gains of its ...Download file to see next pagesRead More
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