Question

Question 1- Discuss briefly the single-person decision theory under the conditions of uncertainty.

Question 2- Discuss the role of net income in firm valuation under the ideal conditions VS. its role under the presence of uncertainty. Does the net income have information content in these two conditions? What basic assumption needs to be changed to make the net income to have information content?

Question 3- Discuss the CAPM model: its content/formula, assumptions and limitations?

Question 4- What does the efficient market mean? How is it achieved?

Answer 1

Question 1- Discuss briefly the single-person decision theory under the conditions of uncertainty.

Information plays a very important role when one has to make decisions. The importance of information becomes even more critical when there is uncertainty about the decision. The single person decision theory makes it clear regarding how a person should take decision when there is uncertainty. This includes decision making regarding the financial decisions of the company. The theory states that an investor should study the financial statements of the company in order to understand the financial position of the company and the uncertainty involved with the financial condition of the company. The theory states that the investor requires the details of the financial performance of the company and the risk that he or she will undertake by investing in the company. This will help the investor to make a wise decision based on the information available. He/she will be able to hedge the risk or diversify the portfolio.

Question 2- Discuss the role of net income in firm valuation under the ideal conditions VS. its role under the presence of uncertainty. Does the net income have information content in these two conditions? What basic assumption needs to be changed to make the net income to have information content?

Net income of the company does not play any important role in the valuation of the firm under ideal conditions. However, under uncertain conditions the net income can be predicted or calculated. The calculation can be done based on the information available about the financial condition of the firm. Thus, net income has information content in uncertain situations but it does not have any information in ideal conditions. In order to make the net income have information content in ideal conditions, one should ensure that the information available should be relevant and reliable.

Question 3- Discuss the CAPM model: its content/formula, assumptions and limitations?

The CAPM or the Capital Asset Pricing Model is the theory that is used to determine the asset price for individual firms. There are several assets available in the market. When a company has to decide the diversification of its portfolio, then it will have to calculate the rate of return that a particular asset will have if the company invests in it.

Assumptions:

• The financial markets are competitive
• The return on asset gives the summary of the investment opportunities of the company.
• All investors plan to invest over the same time period.
• No taxes exist
• The risk free rate is same for all investors
• The information about the assets is the same with all the investors

Limitations:

• The assumptions of the theory are unrealistic
• It states that risk-free assets exist whereas they do not exist in reality.
• It believes that all assets are equally divisible which is impossible
• The value of beta is considered to remain constant whereas it is changeable in reality.

Formula:

The CAPM formula is as follows:

Expected return on the asset = Risk-free rate + Beta [(Average return on the capital market) - (Risk free rate)]

Question 4- What does the efficient market mean? How is it achieved?

Efficient market means that the market has an inherent characteristic of reflecting all the information that is available regarding the stock market. This is also known as stock efficiency. It implies that there is no information that can be hidden in the market. All information will be incorporated and it will influence the share price. Thus, no investor will be able to get more returns or take advantage of the information that is available to him or her specifically. It can be achieved by making all transactions of the company transparent and ensuring that the information is available across all medium.