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Aa Bb CCC ay. AE. .. 1 Normal 1 No Spac... Heading 1 Heading 2 Title Subtitle Paragraph Styles Do you agree with the following statements - explain the reason for the same. a. Shareholders require higher expected rates of return on shares with more variable rates of return. b. Mr. Rahul invests Rs. 5,000 in T-bills and Rs. 15,000 in the market portfolio will have a beta of 1.5 on his investment portfolio. c. Each project should be evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which the capital is put. d. Financial leverage increases the expected return and risk of the shareholder. e. A company declare high dividend payout, with a large proportion of inside ownership, all of whom are high income individuals. Attempt both the questions a) What is pecking-order theory of capital structure? If the theory is right, would you expect very profitable firms to borrow more or less than the average? b) What is WACC? List out the issues involved in estimating the WACC?
Answer: a. Yes, Shareholders always require a higher expected rate of return but its minimum expectation from a particular stock or Portfolio by any investor which mainly depends on Market Return (Rm) & Risk (Beta) because Risk-Free Rate (Rf) is fixed. As Market Return (Rm) increases due to any events, the Expected Rate of Returns also increases but its variable return which fluctuates as per the market performance.
b. As Mr. Rahul invests Rs. 5000 in T-Bills from which he will get Rf (Risk-Free Rate) but Rs. 15000 invest in Market Portfolio. Technically, T-bills is risk-free means zero Beta but a Market portfolio can have any value of Beta which depends on Stocks. Therefore, 1.5 Beta possible.
c. Investment is all about Risk & Returns but there is a Time Value of Money, which varies based on Investment. Opportunity Cost is to search for the best Returns available in the market with the same Risk. Yes, I agree with the statement.
d. Yes, Leveraging investment is a strategy used by many investors which can give higher expected returns with higher risk. Mostly, it is used when the Market is Bullish otherwise it can create huge liability with great risk & low returns.
e. Yes, it is correct because the Company used to promise for an expected Rate of Returns to its preferred shareholders before investing in the company's stocks. But ultimately depends on the performance of the company which can be seen as PAT (Profit after Tax).
a. Pecking Order Theory clearly explains the order of financing sources of Corporations. As per the theory, Companies should first finance themselves internally through Retained Earnings and then go to external sources and then issuing Equity.
Here, it's not a question of true or false. Many Profitable companies engaged in debt financing because they can get debt at a very cheaper rate in the market as they can invest cash in other projects while many other very profitable companies have no debt in their Balance Sheet. So, its depend on Companies, Industry, Market, and future prospects.
b. WACC is the Weighted Average Cost of Capital which is calculated by adding Cost of Equity and Cost of Debt. But we know that there is an Interest Tax Shield, which decreases the Cost of Capital. Furthermore, despite having benefits as Interest Tax Shield, companies should have to maintain an optimal Capital structure because leveraging also creates liability.
So, WACC = Cost of Equity + Cost of Debt (1-Tax).
