Part 1:
Formula of simple interest: Principal*Time period * Interest rate (Brigham, F., and Michael C. 2013)
|
Funds deposited in each year |
||
|
Year |
Amount |
Time |
|
Year 1 |
$ 100.00 |
At the starting of the year |
|
Year 2 |
$ 200.00 |
At the starting of the year |
|
Year 3 |
$ 300.00 |
At the starting of the year |
|
Year 4 |
$ – |
|
|
Year 5 |
$ – |
|
|
Interest Rate for each period |
7.00% |
simple interest rate |
Note: It has been assumed that all funds have been deposited each year and at the starting of the year. It is also assumed that interest gathered in each year is not available for reinvestment in subsequent years.
|
Value of funds deposited after three years using Simple interest |
||||
|
Principal |
Period of investment in years |
Interest Earned |
Initial Amount |
Future Value |
|
$ 100.00 |
3 |
$ 21.00 |
$ 100.00 |
$ 121.00 |
|
$ 200.00 |
2 |
$ 28.00 |
$ 200.00 |
$ 228.00 |
|
$ 300.00 |
1 |
$ 21.00 |
$ 300.00 |
$ 321.00 |
|
$ 70.00 |
$ 600.00 |
$ 670.00 |
|
Value of funds deposited after three years using Simple interest |
||||
|
Principal |
Period of investment in years |
Interest Earned |
Initial Amount |
Future Value |
|
$ 100.00 |
5 |
$ 35.00 |
$ 100.00 |
$ 135.00 |
|
$ 200.00 |
4 |
$ 56.00 |
$ 200.00 |
$ 256.00 |
|
$ 300.00 |
3 |
$ 63.00 |
$ 300.00 |
$ 363.00 |
|
$ 154.00 |
$ 600.00 |
$ 754.00 |
Where:
Systematic risk refers to the beta value and portfolio has higher systematic risk than the average asset as average beta of all beta values for 4 shares is 1.06 which is lower than weighted beta of portfolio (Damodaran, 2011)
Part 1: Total risk refers to the combined value of risk generated through the impact of systematic risks and unsystematic risks. Systematic risk can be measured through use of beat values but there are no set criteria to measure the unsystematic risk. In order to best measure the value of total risk, standard deviation can be used as it measures how much security deviates relative to its mean. So standard is best measurement of total risk. Security that deviates more from its means tend to provide more risk as compare to security that deviates less. So, security A has greater total risk due to high standard deviation (Davies and Crawford, 2011).
Part 2: Systematic risk refers to the market risk and this risk arises due to uncertainty poses in the entire market. This risk can be measured through use of beta coefficient and security which has higher beta value tends to have more systematic risk as compare to security that tend to have lower beta value. In the given case Security B tends to have higher systematic risk as it has higher beta coefficient value.
Part 3: Diversification cannot eliminate the systematic risk as systematic risk arises due to change in market condition. Market impacts all the listed securities equally and in relation to the beta coefficient. So diversification cannot be used to eliminate the systematic risk. Diversification can reduce or minimize the overall beta value of the portfolio but cannot eliminate it.
Part 4: Security market line (SML) refers to the line that represent capital asset pricing model. In case if investment has positive net present value it will have greater return as it is expected which means it will plot above the security market line as expected return is shown on Y axis and beta value on X axis. If return increases value of Y will increase and line which drawn above the given SML line (Davies and Crawford, 2011).
Part A:
Modigliani-Miller has proposed capital structure theories during the period of 1950s for determining the market value of a firm. The theory is developed on the basis of hypothesis that in a perfect structure there is no relatively impact on the type of capital structure of a firm on its operations. They have proposed that the market value of a firm is impacted by its earning power and the risk of the underlying assets. The value is relatively independent by the way the firm selects the method of financing its investments or distributes dividends. The key assumptions that are adopted by them during the development of M&M theory is that there are no taxes, no cost of transaction, market information is symmetric and there is no impact of debt on the earning potential of a firm (Smirnov, 2018). The different M&M positions that have been proposed can be discussed as follows:
M&M Proposition I
It has been stated by M&M proposition I that there is relatively no impact of the leverage used by a firm on its market valuation that it adopts for financing its operational activities. The market value of a firm can be determined through calculating the present value of the cash inflows that is to be realized from its asset base in the future context. As such, as per this proposition the value of an unlevered firm is equal to the value of equity whereas in case of levered firm it is equal to the proposition of debt and equity. Therefore, as per the theory the value of levered firm is equal to the value of unlevered firm as it is dependent on the present value of the future cash inflows. As such, there are no tax shields as per this proposition and thus the market value is not influenced by the changes occurring within the capital structure (Modigliani & Miller’s Propositions in Finance, 2018). It can be depicted by the use of following graph:
(Source: https://financialmanagementpro.com/modigliani-miller-theories-of-capital-structure/)
M&M Proposition II
This proposition has stated that the expected return on equity increases in proportion to the rise in the debt to equity ratio. It is based on the assumption that the average cost of capita of a firm is relatively constant and therefore the firms are not able to gain any benefit from the use of debt in their capital structure. This is because the gains to be realized from the lower cost of debt are offset by the increased expected return on equity (Baker and Martin, 2011). The proposition can be depicted by the use of following graph:
(Source: https://www.graduatetutor.com/corporate-finance-tutoring/modigliani-miller-mm-propositions/)
M&M Proposition III
This proposition has stated that in the present of tax shields the value of a firm is significant impacted by the changes in the capital structure and the expected return on equity increases with the rise in the debt to equity ratio (Miglo, 2016). It can be depicted by the use of following graph:
(Source: https://www.graduatetutor.com/corporate-finance-tutoring/modigliani-miller-mm-propositions/)
part B:
(Smirnov, 2018)
References
Baker, H. and Martin, G. 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. John Wiley & Sons.
Brigham, F., and Michael C. 2013. Financial management: Theory & practice. Canada: Cengage Learning.
Damodaran, A, 2011. Applied corporate finance. USA: John Wiley & sons.
Davies, T. and Crawford, I., 2011. Business accounting and finance. USA: Pearson.
Miglo, A. 2016. Capital Structure in the Modern World. Canada: Springer.
Modigliani & Miller’s Propositions in Finance. 2018. [Online]. Available at: https://www.graduatetutor.com/corporate-finance-tutoring/modigliani-miller-mm-propositions/ [Accessed on: 29 March 2019].
Smirnov, Y. 2018. Modigliani-Miller Theories of Capital Structure. [Online]. Available at: https://financialmanagementpro.com/modigliani-miller-theories-of-capital-structure/ [Accessed on: 29 March 2019].
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