Chp 5 cost of capital

Assumptions of CAPM

• perfect capital market,

  no transaction cost, no taxes, perfect information

• borrowing and lending at risk-free rate

• all returns are over a standard single-period transaction horizon, one year

• only systematic risk as it makes assumptions that all investor hold diversified portfolio

• consider total risk can be reduced by diversified portfolio

Answer explanation

consider total risk can be reduced by diversified portfolio - portfolio theory

CAPM anly consider systematic risk

Systematic risk

• risk that can't be removed by portfolio diversification

• risk that can be removed by portfolio diversification

• risk that relates to the financial system as a whole that can't be avoided by any company

• contains both business risk and financial risk

• investing shares between 20-30 companies can eliminate the risk

Answer explanation

Portfolio diversification- holding range of different investment.

Risk can be reduced by holding several different investment.

Different investment are affected to different extent in changes in economic e.d inflation and interest

Unsystematic risk

• risk that can't be removed by portfolio diversification

• risk that can be removed by portfolio diversification

• risk that relates to the financial system as a whole that can't be avoided by any company

• contains both business risk and financial risk

• investing shares between 20-30 companies can eliminate the risk

Answer explanation

Portfolio diversification- holding range of different investment.

Risk can be reduced by holding several different investment.

Different investment are affected to different extent in changes in economic e.d inflation and interest

Which of the following best describes systematic risk?

• The chance that automated processes may fail

• The risk associated with investing ni equity

• The diversifiable risk associated with investing in equity

• The residual risk associated with investing in a well-diversified portfolio.

Which of the following are assumed if a company's current weighted average cost of capital ('WACC) is to be used to appraise a potential project?

• Capital structure will remain unchanged for the duration of the project

• The business risk of the project is the same as the current business operations

• The project is relatively small in size

Which of the following assumptions is not required when using the capital asset pricing model to estimate the cost of equity for project appraisal?

• Efficient capital markets

• Well diversified investors

• Future periods are consistent with the present

• Companies are well diversified