Question

Explain residual risk as it relates to common stock ownership. Do fixed income instruments have residual risk? Explain sunk costs and externalities as they pertain to capital budgeting. How should they be treated, if at all? Finally, explain the use of lattices in graphically explaining option valuation. What does the lattice help to visually explain?

Answer 1

Residual equity theory assumes that the common shareholders to be the real owners of a business. Their residual income is calculated by subtracting the claims of bondholders and preferred shareholders from a company's assets.The Residual risk is company-specific risks, such as strikes, outcomes of legal proceedings or natural disasters etc. But this risk is diversifiable hence this risk can be tolerated in case of company going bankrupt and in turn the Residual equity theory comes into picture.

Yes, the fixed income also has residual risk associated with it.

Sunk costs are those which has already incurred and cannot be recovered and due to this fact this cost is ignored while making capital budgeting decisions.

Externality is a positive or negative consequence of an economic or financial activity which is to be faced by a third party individual. Marginal benefit and marginal cost curves are used to measure externalities.