Question

1. a. Assuming you have two projects A and B and both of them have negative NPV and IRR less than cost of capital. Is there conflicts of interests between stockholders and bondholders? If so, why do they have conflicts? Please give two examples/situations where there is conflict of interests between the two parties.

1. b. Discuss the benefits of diversification among different stocks. What is the limiting case of diversification. If you can only buy stocks, can you diversify away market risk?

Answer 1

Answer(a): If the project has negative NPV and IRR less than cost of capital then the project should not be approved. NPV is the Net asset value and IRR is Internal rate of return, these both are very important while taking project approval decision.

In this question, conflict can arise because of approval of the project, bondholders may want that the project should be approved because bondholders will keep getting their interest income while on the other hand, if project is not profitable, shareholders will not get any dividend because dividend is paid out of the profits only.

There is conflict between shareholders and bondholders related to many situations/ topics, for example:

• Dividend payout policy
• Asset Substitution
• Underinvestment
• Claim Dilution etc.

Answer(b): Diversification- It is the art of putting your money into different stocks of different industries or to put your savings into different Asset class.

Benefit of diversification: Are as following:

1. It minimizes unsystematic risk that can arise by investing into one stock or sector. Diversification reduces risk by Asset Allocation.
2. Diversification gives the benefit of return from many stocks at a single time, if one stock or sector is not doing well, other stocks are performing good then the portfolio will be balanced and will reap good returns.

Limitation of Diversification- In spite of above benefits, there is one limitation of diversification. Diversification can be done when there is unsystematic risk. Unsystematic risk is the risk, related to particular stock, company or industry. This can be easily diversified by diversification.

As far as Systematic risk is concerned, it cannot be reduced by diversification. Systematic risk is the market risk that affects overall stock market due to economic or political changes. Systematic risk or market risk cannot be minimized or diversified through diversification, this is the biggest limitation.