Question

Client’s Financial Questions:

 What is the Capital Asset Pricing Model (CAPM) and how is it used to evaluate whether the expected return on an asset is sufficient to compensate the investor for the inherent risk of the asset?

 What is an efficient capital market and why market efficiency is important to financial managers?

 Identify the assumptions that are necessary to make the general dividend valuation model easier to use, and, in doing so, to be able to use the model to calculate the value of a company’s ordinary shares.

 Explain net present value (NPV) as a capital budgeting tool and how NPV is used for the evaluation of a capital project.

Answer 1

Answer A: CAPM Model tells us the Relation ship between systematic risk and required return for an asset.

Model Equation is

Expected return = Risk free rate + beta * (market return - risk free rate)

Beta Measures the Volatility associated with the risk. If the expected return for a given beta does not satisfy the investor he may choose not to invest that's how an investor can make a decision regarding that return is sufficient or not

Answer B: Efficient Capital market theorem states that Stock prices fully reflect all the information available in the market regarding the stock.

Financial managers have to take decision regarding investment across Companies if complete information is not able in the market they may take wrong decisions leading to the loss for them that's why complete transparency is required in the market

Answer C: Future Dividends of a company are uncertain and some companies may not pay dividend at all.

To make the model workable and calculate value of stocks based on that we make assumptions regarding the dividend payments and try to confirm it to particular patterns like

1. Zero growth model

2. Constant growth model

3. First growth then Constant

Answer D: Net present value is the Summation of all Discounted values of expected cash flows. A difference between outgoing and incoming cash flows present value.

Present value formula = Cash flow/(1 + Discount rate)^(no of years)

It is a very useful tool as it takes the time value of money in to consideration.

If NPV comes out to be positive that means it is beneficial to opt for the project.