BUSF_A01.qxd

Suggested answers to review questions

7.3 There is no other portfolio that will give a higher expected return for that portfolio’s

level of risk, and there is no other portfolio that will offer a lower level of risk for

that portfolio’s level of return.

7.4 It means that all rational, risk-averse investors will choose to invest their wealth in

some combination of the market portfolio of risky investments and a risk-free

deposit (at the risk-free rate). The risk-free investment might be a negative one, in

other words, borrowing, for the less risk-averse investors.

7.5 The statement is not true. The beta relates only to the risk premium. Thus the risk

premium of the former security will be expected to be twice that of the latter. In

either case, the total return is the risk-free rate plus the risk premium.

7.6 This is justified on two grounds:

lThe stock market is a free, efficient and observable market where risky invest-

ments are bought and sold. It thus provides us with the basis of price for risky

investments not actually traded in that market.

lThe returns from real investments made within businesses feed through to the

investment returns of those businesses’ shareholders. Thus there is a clear link

between real investment returns and stock market returns.

8.1 Loan finance is risky to the borrowing business because the business must meet

contractual obligations (normally) to pay interest and repay the principal of the bor-

rowing on the due date. Failure to meet these obligations could cause the business

to be put into liquidation, with resulting losses to shareholders. By contrast, equity

finance does not create these obligations.

8.2 If profits are paid out to shareholders as a dividend, the cash can be invested by the

shareholders to generate an income. If profits are retained, there is an opportunity

cost to shareholders for which they will require compensation from the business,

equal to the value of that lost income.

8.3 The cost of ‘raising’ retained profits is zero. Unlike other forms of raising equity, no

administrative or legal costs have to be paid. This makes it very cheap to raise

finance by retaining profit. Also, provided that profits have been made, retained

profits represent a pretty sure means of raising finance. Other ways of raising equity

depend on decisions made by those to whom new shares are issued. Although the

risk that investors will not buy new shares can be insured against through under-

writers, the fees involved tend to be rather high.

8.4 Except where the loan notes have just been issued, it would be unusual for the

coupon rate to equal the pre-tax cost of the loan to the business. Interest rates pre-

vailing in the economy vary over relatively short periods of time. To cause the

return from the loan notes (which is fixed as the coupon rate) to represent the mar-

ket level of return, the market price of the loan notes will move away from its issue

price. Also, some loan notes are issued at a discount or redeemed at a premium on

the value at which the coupon rate is calculated. In this case the 10 per cent does not

represent the complete return from the loan notes.

8.5 Convertible loan notes are those that shows all of the characteristics of pure loan

notes until some predetermined date at which loan note holders will be offered a

number of ordinary shares in the business in exchange for their loan notes.

Chapter 8

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