Questions and Answers Financial Debt

Question

Debt is the main reason large companies have significant differences between the 25% and 75% quartiles, specifically focusing on the Asset Turnover, Net Profit Margin, and Equity Multiplier. Significantly, a debt increment gives the firm extra cash that it can utilize the cash for business expansion. Consequently, this increases the firm’s returns without sharing its earnings with the creditors. Debt is deemed a cheap option by the firm because after making payment of the principal and the interest, the interests are shared between the firm’s owners. However, it can also adversely impact small firms especially concerning payments to creditors (Berk and DeMarzo, 2016).

Consider two major firms in the United States, Amazon, and Walmart. Concerning the asset turnover, it is conceivable to determine whether the firm’s total assets are efficaciously converted into sales. A firm’s total assets, as well as sales, are influenced by debt. The outcome of the ratio will solely be determined in terms of the quickest rate of change. For instance, if Walmart’s total assets increase by 5 percent whereas the sales increase by 10 percent, it implies that there will be an increment in the asset turnover. It implies that debt acquired facilitates sales growth (Graham et al., 2020).

When considering the net profit margin for Amazon, debt usually substantially influences the firm’s sales. This is for the reason that if the firm opts to expand the business using debt, its operational capability at a larger scale will increase, consequently resulting in greater sales. The debt increment will also increase the interest expenses of the firm, which provides a tax shield to the firm by diminishing the taxable income (Graham et al., 2020).

Question 2

There is contention between the main objective being either the maximization of shareholder wealth or the maximization of stakeholder wealth. In my perspective, maximizing shareholder wealth is the more appropriate primary objective of the firm. Based on definitions, it is perceptible that a shareholder is a component of a stakeholder. However, arguing that stakeholder interest is greater contrasted against shareholder wealth also implies considering all stakeholder interest objectives. It is hard to implement this because different stakeholders bear conflicting or dissimilar objectives (Nicholas and Sacco, 2018).

On the other hand, maximizing shareholder wealth is an objective with the sole value that emphasizes the firm owners. According to this, it facilitates the total value creation of the company. Consequently, it promotes every stakeholder group to attain a greater share, including employees, suppliers, investors, and others. Therefore, it is essential to maximize shareholder wealth (Ho, 2010).

Question 3

The Dividend Discount Model (DDM) is one of the most basic stock valuation approaches. The DDM approach computes the “true” value of a company’s stock based on the dividends the firm pays its shareholders. This approach supposes that investors lack control over the firm’s payout policy (Larrabee and Voss, 2012). Secondly, the Free Cash Flow (FCF) approach considers the firm’s cash flows. It is critical to note that these two approaches are largely associated with one another. The fundamental dissimilarity is that we examine all the cash flows accessible for distribution to the investors and utilize them to attain value for the whole firm. Bearing that we are utilizing the cash flows for all investors, it is necessary to discount them based on the weighted average cost of capital and not the expected return on equity (Luecke, 2002).

Question 4

Interest can be classified as either simple interest or compound interest. On the one hand, simple interest is computed on the original loan amount, also referred to as the principal. Alternatively, the compound interest is computed on the principal loan amount and the massed interest of the preceding periods (Corporate Finance Institute, 2022). It is imperative to point out that there can be a significant disparity in the amount of interest payable on a loan if the interest is computed using compound interest instead of simple interest (Besley and Brigham, 2014).

Assume the principal loan amount is $10,000, the interest rate is 5%, and the period is three years.

1. Using simple interest

$10,000 × 5% × 3 years

2. Using compound interest

This example indicates that compound interest generates a higher interest amount than simple interest.

Question 5

Investors are usually compensated for taking a systematic risk, also known as market risk. However, they are usually uncompensated for taking an unsystematic risk, also referred to as firm-specific risk. Considering my comprehension of CAPM, the notions of standard deviation and variance, and market efficiency, I believe this is a good theory.

Two fundamental reasons support my position. The first reason is that the investors taking into consideration total risk have a likelihood of losing out on investing in a firm, as compared to the investors who only consider marketing, with all other factors remaining constant. In a market comprising numerous diversified investors competing with one another to invest in firms, the most likely outcome is that the undiversified investor will remain unrewarded if there is a continued demand for compensation for total risk (Swedroe, 2015).

The second reason is that a firm’s managers may solely consider market risk when assessing projects for the firm to invest in. Managers may face a temptation to utilize the higher rate based on adequate compensation for the total project risk. Investors could attempt to supplant the firm’s board of directors if the manager proceeds to remain conservative and utilize total risk. Nonetheless, if incapable of doing so, they could opt to sell their shares, consequently causing the firm’s stock price to deteriorate (Damodaran, 2012).

Question 6

Berk and DeMarzo (2020) pinpointed one bias: individual behavior and market prices. Individual investors are under-diversified and carry out excessive trading, violating a fundamental prediction of the Capital Asset Pricing Model (CAPM) (Berk and DeMarzo, 2020). When we amalgamate their portfolios, suppose individuals diverge from the CAPM in random, distinctive manners, even though every person does not hold the market. In that case, these divergences will tend to negate like any other idiosyncratic risk. In this regard, persons will hold the market portfolio in aggregate, and there will be no impact on market prices or returns. These unacquainted investors may be trading with themselves, producing trading profits for their brokers, but devoid of affecting the efficiency of the market. Therefore, for the behavior of unacquainted investors to affect the market, it is essential for there to be patterns to their behavior that sway them to diverge from the CAPM in systematic ways and, as a result, convey systematic ambiguity into prices.

The second one is systematic trading biases. Specifically, for individual investors’ trading behaviors to influence the market prices and therefore generate a profitable prospect for more sophisticated investors, it is imperative for there to be expectable systematic patterns in the sorts of blunders made by individual investors. It is imperative to point out that investors tend to hold on to stocks that have experienced a loss in value; and, on the other hand, opt to sell stocks that have experienced an increase in value from the time of buying such stocks. This inclination to hang on to losers and sell winners is the disposition effect (Shefrin and Statman, 1985).

Question 7

A basic principle in investing in bonds is that the bond prices and the market interest rates have an inverse correlation. The rise in market interest rates results in the fall of the prices of fixed-rate bonds. In the same manner, when the cost of borrowing money declines, causing the interest rates to decline, it implies that the prices of fixed-rate bonds rise. This correlation is referred to as the interest rate risk. Several risks are taken into consideration when making investments in bonds. First, as indicated above, there is interest rate risk. In general, increasing interest rates will lead to declining bond prices. Consequently, this mirrors the capability of investors to attain an appealing interest rate on their money elsewhere. The vice versa is true (Merna and Al-Thani, 2008).

A second risk is credit risk. This encompasses the risk that an issuer will be incapable of making interest or principal payments when they are due and, as a result, default. Various rating agencies appraise the credit worthiness of issuers and hand out credit ratings based on their capability of repaying obligations (Tuckman and Serrat, 2011). Third, there is liquidity risk, which alludes to the risk that investors may face a tough time obtaining a buyer when they wish to sell and are therefore compelled to sell at a considerable discount to market value. To minimize liquidity risk, investors may endeavor to go for bonds that are a component of a major issue size and most recently issued bonds (Tuckman and Serrat, 2011). There is also an inflation risk. It is critical to point out that inflation diminishes the purchasing power of the future coupons of a bond and the principal. Considering that bonds do not usually offer astonishingly high returns, they are especially susceptible when there is a rise in inflation. Notably, inflation may result in higher rates of interest, which are adverse to bond prices (Tuckman and Serrat, 2011).

Question 8

The quote “If that were a real $100 bill lying there, somebody would already have picked it up!” has insightful implications and ramifications for comprehending finance and market efficiency. First, this quote signifies the principle of efficiency and its limitations. Specifically, in finance, the efficient-market hypothesis insists that financial markets are efficient regarding information. In line with this, it is not possible for one to incessantly attain returns that are more than average market returns based on risk adjustments, taking into account the accessible information precisely the time of investing (Pennant-Rea and Crook, 1986).

The intent of the student leaning down to pick the $100 bill that is lying on the pavement signifies the economic decisions made by investors. Notably, this indicates that investors are systematically irrational. Mostly, they make decisions based on emotions. Such decisions are usually centered on unstable hypotheses and are usually fast to perceive cause and effect in areas where there may be none (Banerjee, 2009). Bearing this in mind, it is imperative to note that the market has deemed a mechanism that makes the most of the joint information of participants in the stock market to generate efficient prices and that there is no easy money. This implies that the easy money, such as the $100 bills lying on the Ground, that investors can easily make in making predictions on the behavior of stocks does not exist. This implies that it is difficult to toy around incessantly with and beat the Standard and Poor (S&Ps) 500 Index (Siegel, 2002).