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1. Define Diversifiable and Non-diversifiable Risks. In broad terms, why is some risk diversifiable? Why are some risks non-diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk? - Diversifiable risk more commonly known as unsystematic risk, which is a risk that specifically affects a particular asset or a small group of assets, not the entire company. The same can be applied for the bigger picture, as the danger of an event that would affect an industry and not the market. Example, if a local oil company announced a small oil strike, itself and maybe few others local companies may be affected but not the world oil market. - Non-diversifiable risk or systematic risk, is any risk that affects a large number of assets, each to a greater or lesser degree. An unanticipated or surprise increase in inflation affects wages and the costs of the supplies that companies buy, the value of the assets that companies own, and the prices at which companies sell their products (everything would be affected. Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns. 2. What are the differences between internal and external financing? Internal financing comes from internally generated cash flows and does not require issuing securities for example owners capital , retained earnings and selling assets. In contrast, external financing requires the firm to issue new securities such as stocks, bonds, bank loans. 3. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer? Beta is the measure of the systematic risk that is associated with the portfolio or the asset. It represents the fluctuations in the stock returns. Beta is used in the CAPM to calculate the value of the expected return of the asset. It is true that a portfolio can be constructed with a zero beta. The risk-free rate as well as the expected rate of return with the zero beta will be the same. Also, it is possible to construct a portfolio with a negative beta. In this case the return of the portfolio will be less than the risk-free rate. The negative risk premium is always present with a negative beta. The reason is its value as a diversification instrument. Lastly, to create an asset with a negative beta, short position is taken on the asset with positive beta.

4. What are the differences between preferred stock and debt? Preferred stock (cannot vote) combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price. This appeals to investors seeking stability in potential future cash flows. The differences between preferred stock and debt are: a. The dividends on preferred stock cannot be deducted as interest expense when determining taxable corporate income. From the individual investor’s point of view, preferred dividends are ordinary income for tax purposes. For corporate investors, 70% of the amount they receive as dividends from preferred stock are exempt (excused from income taxes.) b. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to common stock. Basically, debt gets to be paid first then the preferred stock followed by the others c. There is no legal obligation for firms to pay out preferred dividends as opposed to the obligated payment of interest on bonds. Therefore, firms cannot be forced into default if a preferred stock dividend is not paid in a given year. Preferred dividends can be cumulative or non-cumulative, and they can also be deferred indefinitely (of course, indefinitely deferring the dividends might have an undesirable effect on the market value of the stock). 5. What are the main differences between corporate debt and equity? Why do some firms try to issue equity in the guise of debt? Debt Equity Repayment is an obligation of the firm Yes No Grants ownership of the firm No Yes Provides a tax shield Yes No Liquidation will result if not paid Yes No Companies often issue hybrid securities because of the potential tax shield and the bankruptcy advantage. If the IRS accepts the security as debt, the firm can use it as a tax shield. If the security maintains the bankruptcy and ownership advantages of equity, the firm has the best of both worlds.a 6. What are the differences between financial (capital) lease and operating lease? Aspects of Difference DEFINITION

Operating Lease

Financial (Capital) Lease

A lease in which all risks and rewards related to asset ownership remain with the lessor for the leased asset is called an operating lease. In this type of lease, the asset is returned by the lessee after using it for the agreed-upon

In a financial lease (also known as a capital lease), the risks and rewards related to ownership of the asset being leased are transferred to the lessee. Read

Aspects of Difference

Operating Lease

Financial (Capital) Lease

lease term. Read more about Operating Lease for in-depth coverage.

this article on Finance Lease for more in-depth coverage.

OWNERSHIP

The ownership of the asset remains with the lessor for the entire lease period.

The ownership transfer option at the end of the lease period is available to the lessee. The title may or may not be transferred eventually.

ACCOUNTING EFFECT

An operating lease is generally treated like renting. That means the lease payments are treated as operating expenses and the asset does not show on the balance sheet.

A financial lease is generally treated like loan. Here, asset ownership is considered by the lessee, so the asset appears on the balance sheet.

ASPECTS OF DIFFERENCE

Operating Lease

Financial (Capital) Lease

PURCHASE OPTION

In an operating lease, the lessee does not have an option to buy the asset during the lease period.

A financial lease allows the lessee to have a purchase option at less than the fair market value of the asset.

LEASE TERM

The lease term extends to less than 75% of the projected useful life of the leased asset.

The lease term is generally the substantial economic life of the asset leased.

EXPENSES BORNE

The lessee pays only the monthly lease payment in an operating lease.

In a financial lease, the lessee bears the cost of insurance, maintenance, and taxes.

TAX BENEFIT

Since an operating lease is as good as renting, the lease payment is considered an expense. No depreciation can be claimed.

The lessee can claim both interest and depreciation, as a financial lease is treated as a loan.

RUNNING COST

In an operating lease, no running or administration costs are borne by the lessee, including registration, repairs etc., since this lease gives only the right to use the asset.

In a financial lease, running costs and administration expenses are higher and are born by the lessee.

EXAMPLE

Projectors, Computers, Laptops, Coffee Dispensers, etc.

Plant and Machinery, Land, Office Building, etc....