CAPM the First Scenario Represents a Diversifiable

CAPM

The first scenario represents a diversifiable risk. The rate of inflation has an effect on the whole economy, but the nature and direction of that effect is something that will be different for each firm. Some firms may suffer more than others from the effects of a higher rate of inflation, depending on their business model, their capital structure and their strategy. In addition, inflation rates are a national phenomenon. It is easy to diversify beyond the borders of the United States. There are American companies that do over half of their business overseas. There are also ADRs of foreign companies that are traded in New York. It is easy enough to diversify out of the effects of even a broad-based economic factor like the inflation rate.

A major recession in the U.S. is something that might affect the whole market, but again how it affects each individual firm is going to be subject to that firm's business and its structure. A fully diversified portfolio will go down during a recession because the broader market will go down. However, there are always going to be companies that benefit from recessions -- Wal Mart and Family Dollar both did. There will also be companies whose stocks are not related to the market index much -- companies like Apple and Starbucks saw great stock performance during the recession. In that sense, it might pay to be less diversified in the recession as opposed to more. But there are always securities with low or even negative betas, and a move into those securities would allow for the investor to outperform the market, even if the portfolio needs to see reduced diversification in order for that to happen.

1c. A lawsuit against a corporation can be fully diversified against. This is very much a firm-specific risk, so a properly diversified portfolio will essentially remove this risk from the portfolio.

2a. CAPM: Ra = Rf + ?(Rm-Rf)

12 = 4 + (1.2)(Rm-4)

8 = 1.2R -- 4.8

12.8 = 1.2R

R = 10.667

2b. CAPM: Ra = Rf + ? (Rm-Rf)

9 = Rf + (0.8)(10-Rf)

9 = Rf + 8-.8Rf

1 = .2Rf

Rf = 5

2c. If I owned half the stocks on the stock exchange, I would expect the beta to be 1. Any portfolio that is fully diversified would have an expected beta of 1, given that at that point the portfolio is no longer subject to firm-specific risk. Once the unsystematic risk is eliminated, only systematic risk remains, implying a beta of 1. Half of the stocks on the stock exchange is very likely to be a fully diversified portfolio, because not only are a large number of stocks in the portfolio but with that many all the major industries are going to be represented as well.

Part II.

There are a number of advantages for AMSC to take on equity financing. The first advantage is that equity does not create a drain on cash flows the way that debt does. With debt, interest payments are an obligation that must be made before the company either pays dividends or reinvests in the company. Thus, if AMC wants a better return for its shareholders, or more money to plow back into the business, equity financing is a better choice. Additionally, it is desirable for companies to align the time frame of their financing with the time frame of the project for which they want the financing. Additionally with equity financing the company is not going to be subject to restrictive covenants, which can be attached to debt and often create problems for management by setting limits, for example on the debt-equity ratio. A few bad quarters could reduce retained earnings enough to trigger a covenant, for example, creating a problem that management must solve.

There are disadvantages, however, to using equity. The biggest disadvantage is that equity financing costs more than debt financing. While debt increases the risk associated with the firm's cash flows (leverage), equity financing costs more because the payouts to the investors are uncertain. In order to compensate for this uncertainty, the company must return more to the shareholders, otherwise nobody would invest in the firm; they would invest in the firm's debt. In addition to the high cost of equity, a subsequent equity issue like this one dilutes the value of the firm's equity for existing shareholders. Given that management is supposed to be acting in the best interests of shareholders, it is bad form to put it mildly to dilute the value of the equity that the shareholders have.

In this situation, I agree with AMSC, for two reasons. The first reason is that the company is taking advantage of what is probably a temporary boost in the stock price. The boost is occurring because of a high profile even that has garnered the company and its products media attention. Selling addition shares at these inflated levels means that the company is going to have a lower cost of equity today than it would have had with an equity issue earlier in the summer. It is this change in the cost of equity -- as a percentage of the return shareholders demand relative to the stock price -- that has shifted the best available option from debt to equity. Additionally, the run-up in the company's stock price means that even with the dilution, current shareholders are still probably ahead of where they would otherwise be without the media attention.

The second reason that I agree with the decision is because AMSC appears to intend to use the proceeds for long-term growth at the company. There is no discussion in the article of any specific projects for which the funds are being raised. Typically, if a company is investing in building the company over the long-term, either equity financing over a debenture would be the optimal choice. The five-year term loan proposed was not as closely aligned with the company's investment plans as an equity issue is.

The company's cost of equity is determined by the current cost of equity, using the capital asset pricing model. This must be adjusted, of course, for the fees that the underwriter charges for bringing the shares to market. Those fees are also incorporated into the cost of equity.

There are tax implications for the choices that the company makes. Debt financing results in interest charges to the company. Interest is taken as an expense prior to the calculation of the company's tax. Therefore, interest expense lowers the taxes payable of the firm. This is not the case with equity financing. Equity payouts -- dividends -- are taken from after-tax dividends. The shareholders are also taxed on these distributions, creating the situation of double-taxation. Therefore, debt financing has an advantage in terms of taxation that only serves to further lower the cost of capital for the company. However, if the company does not intend to pay dividends, then the tax implications are less of a concern, as all profits will be reinvested in the company.