Question

The objective of firms is to maximise the shareholders’ wealth.  By doing so, management should make the best decisions for its financing and investing to create value in shareholders’ interest.  Thus, the information pertaining to firm’s financial decisions should be incorporated into its stock price.  As a junior fund manager, you are tasked to analyse the possible value of firms’ information in your investments.

Required:

1. You believe that both financing and investing decisions contain new information of firm value perceived by the investors.  Thus, stock price reacts positively or negatively to it.  List three decisions each for financing and investing of firms.

2. If you believe Capital Asset Pricing Model (CAPM) is true on pricing the risky securities, what would be the impact of firm’s decisions on your investment value or strategy.

3. Hedge fund managers believe that event-driven investment strategy, i.e. announcements of firm’s financing and investing decisions, could possibly generate abnormal or excess portfolio return.  Do you agree with this statement and why?  State your assumptions when necessary.

Answer 1

1.A. Three decisions each for financing and investing of firms are as follows-

I. Capital budgeting decisions which will include investment into new projects by the company which are profitable

II. Capital structure decisions which will include the mix of different kinds of financing into the capital structure

III. Working Capital Management which will include management of current asset and current liabilities.

three type of investment decision can be ownership decision, lending decision and cash investment decision.

B. If I believe that the Capital Asset pricing model is true on pricing of risky securities, the impact of foreign decision would be that it would always be commanding a risk premium for the investment into risky assets because risky assets are always commanding a market premium in respect to the risk-free Asset and firm decision should always be to invest into risk free or risky assets based upon the risk appetite of the management and if it thinks that the return is worth taking the risk, and it is higher than the overall cost of capital,it will take the risk.

C. Announcement of firm financing and investing decisions could possibly generate abnormal or excess portfolio return because these are the Investment decisions that could probably change the overall direction of the company in the long run so these are the capital expenditure that are looked after by various investors if the company has the capacity of expansion by beating the cost of capital through generation of the excess return on capital & those effect would be positive effect and if the company is not able to generate effective rate of return to beat the cost of capital then, affect will be negative on the overall stock price, and it will leading to a solvency risk for the company.