Corporate finance fundamentals and applications

Corporate Finance

Risk has a disproportionate effect on small businesses when compared to large businesses. Often, small companies, such as those listed in the Russell 2000 stock index, are subject to a greater level of risk exposure given the volatility of sales and other factors that affect revenue as well as drive costs higher. The risk of defaulting on debt obligations for a small business is greater than that of a larger business given the assets owned and the ability to leverage debt and equity to yield revenue whilst paying the charges incurred for issuing debt or the cost of capital to finance operations.

A small company is not likely to pay out a dividend as the intention of a small company is to get larger and therefore the retained earnings is likely to be reinvested into the company and not redistributed in the form of dividend payments. The risk associated with a small firm is similar to the risks associated with any structure that has limited size and capital available to continuously meet and exceed a diversified set of obligations.

An example of a company whose size hinders and presents a disadvantage is are such companies such as those within the Consumer Durable Goods industry. The Imation Corporation (IMN) has a small market cap relative to the larger companies in the industry. Therefore, the company inherently faces more risk than the big cap companies. The ability for larger cap companies to generate revenue as a function of assets under management and to issue debt to finance operations makes the larger cap companies less risky than the small cap companies. (SeekingAlpha, 2009)

Therefore, the risk associated with a large company is less when compared to that of a smaller company. Inherently, there is less capital under management and more competition facing the small company. Ideally, the small company is specialized and has a competitive advantage and a unique strategy that is able to penetrate the market and increase market share.

Pg. 348 -- Problem 8-14

8a.) Given the basis of range, project A exhibits the least risk

8b.) Project A has the lowest standard deviation. Standard deviation is the scatter of returns around the mean. Standard deviation is not the most appropriate measure of risk in this comparison as the SD is an inexact measure of risk spread. The standard deviation coupled with the variance does provide a clearer picture of the inherent risk involved with an investment.

8c.)

8-14

Based on the findings, the recommended alternative is Alternative two. Alternative two offers a relative high expected rate of return when compared to the two alternative choices (1 & 3). Additionally, alternative 2 provides the lowest coefficient of variation as well as the lowest standard deviation. The level of risk given the expected return is high and offers stability when compared to the other alternatives.

8-22

a. Stock B, stock A, stock C

b. If the market portfolio has a return of 12%, then stock a will realize a return of just below 12% or .096%. Stock b will have a return of 1.4 * 12% or .168%. Stock c will have a return of -.30 * 12% or -.036%

c. If the market portfolio has a negative return of 5%, then stock a will realize a return of -.04%. Stock b will realize a return of -.07%. Stock c will realize a return of -.015%

d. If the stock market were about to experience a decline, then the stock to add to the portfolio would be the stock with the lowest or negative beta, which is -.30 or stock c.

e. A major stock market rally would entail a pursuit of stock b, which has a beta of 1.40