Question

1. What is the slope of the security market line (SML)? What is the intercept?

2. Describe relationship between a debt ratio and the firm's value?

Answer 1

Answer(1):

SML- Security market line is the line, drawn on the charts to show the graphical representation of Capital Asset Pricing model (CAPM). This line shows different levels of systematic risk of different marketable securities, plotted against the expected return of the market at a particular time.

The risk free rate is located at the Y- intercept. The purpose of the graph is to identify the action of slope, of the market risk premium. The line represents risk-return trade off. Any security, plotted above the SML, is considered undervalued while a security below the line is overvalued.

Answer(2):

Debt Ratio- it is a leverage ratio that is calculated by dividing all the liabilities by total assets. A lower debt ratio is good, debt ratio higher than 1 says that company has more debt than assets.

Formula: Debt Ratio = Total Liabilities / Total Assets

Relationship between a debt ratio and the firm's value- Higher debt in company's balance sheet is not good because higher debt brings interest burden and obligation with it. Company's liabilities increase that is not good in longer term. Company has to pay higher amount of interest that decreases net profit available for equity shareholders. Heavy debt affects firm's value. Higher debt represents the claims of the creditors at the time of liquidation. Company that already has heavy debt, cannot get more funds through debt. Company may default in repaying debt that will be bad for its image in the market. Investors also do not invest into the companies with higher debt.