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.

a. 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.

Answer 1

1.a. When I will believe that the Capital Asset pricing model is true on pricing the risky securities as it will mean that Risky securities will always be charging an additional market premium for their investment because those risky securities have the capability of returning higher rate of income.

It can be seen through the Capital Asset pricing formula, that there is a market premium which is calculated after deduction of the market rate of interest.

Risky securities are always known for the potential of returning of a higher rate of return than the rate of return of the risk free assets, so they will be commanding a market premium in respect to the overall risk free Assets and the investor should be always ready to pay a higher rate of premium on pricing when he wants to invest into the risky assets so Capital Asset formula is also advocating the same thing and it will impact the firm decision on my investment strategy because if I am a risk averse investor, I would always be going for the risk free assets where as if I am risk loving investor, I will always be going for the risky assets.

I would also compare the rate of the return of the firm from the cost of capital of the firm because it will mean that the differential between them on the positive side would lead to a growth of the firm and I would always be taking risk for such kind of company and it will help be maximize my rate of return.