ESSAY QUESTIONS
1. What are the advantages of using the SML approach to finding the cost of equity capital?
What are the disadvantages? What are the specific pieces of information needed to use
this method? Are all of these variables observable, or do they need to be estimated? What
are some of the ways in which you could get these estimates?
2. Explain what is meant by business and financial risk. Suppose Firm A has greater
business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital?
Explain.
3. Explain 1) the factors that determine a security’s beta and 2) how asset beta relates to
equity beta.
4. In order to calulate the firm’s overal cost of capital (RWACC), should book value or
market value weight should be used? Explain.
5. Why should a financial decision maker such as a corporate treasurer or CFO be
concerned with market efficiency?
6. Suppose your cousin invests in the stock market and doubles her money in a single year
while the market, on average, earned a return of only about 15 percent. Is your cousin's
performance a violation of market efficiency?
7. Explain why in an efficient market all investments have an expected NPV of zero.
8. Define the three forms of market efficiency.
9. Identify the general rights that are commonly granted to common stock shareholders.
10. Explain the main differences between debt and equity.
11. Describe some of the sources of business risk and financial risk. Do financial decision
makers have the ability to "trade off" one type of risk for the other?
12. In each of the theories of long term capital structure (with/without tax) the cost of equity
rises as the amount of debt increases. So why don't financial managers use as little debt as
possible to keep the cost of equity down? After all, isn't the goal of the firm to maximize
share value and minimize shareholder costs?
13. 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.
14. In a world with no taxes, no transaction costs, and no costs of financial distress, is the
following statement true, false, or uncertain? Moderate borrowing will not increase the
required return on a firm’s equity. Explain.
15. Is there an easily quantifiable debt-equity ratio that will maximize the value of a firm?
Why or why not?
16. What is the pecking order theory and what are the implications that arise from this
theory?
17. The Direct Interactive Publishing Company is planning to raise $200 million dollars in
new capital. There are currently 50 million shares outstanding with an estimated market
price of $60 each. The corporate officers are debating whether to use a rights offering
(with or without a standby underwriting) or have the issue fully underwritten. The
company is currently listed on a regional exchange and plans to list on a national
exchange after the security issue. List and explain three advantages/disadvantages of each
issue method.
18. Discuss the stages of venture capital financing, defining each in detail.
19. Suppose you look in the newspaper and see ABC trading at $50 per share. Calls on ABC
with one month to expiration and an exercise price of $45 are trading at $6.50 each. Puts
on ABC with one month to expiration and an exercise price of $55 are trading at $3.50
each. Are these prices reasonable? Explain. (Ignore transactions costs.)
20. Suppose XYZ is priced at $125 a share. The 150 call has six months to expiration and is
quoted at $.05. Why do you suppose investors would be willing to purchase a call that is
so far out of the money?
21. Explain the rationale behind the statement that equity is a call option on the firm's assets.
When would a shareholder allow the call to expire?
22. Restrictive short-term financial policies regarding current asset management include
three basic actions. List and briefly describe each action.
23. In working capital management, there are some actions that increase cash. What are
some of the items that increase the cash account, respectively?
24. There are a number of ways firms can deal with financial distress. Identify at least 5 of
these.
25. Financial distress may benefit firms if it prompts them to "restructure their assets".
Explain what this means and how it can be beneficial.