A diversifiable risk refers to risk that an investor can eliminate if he held an efficient portfolio while a non-diversifiable risk refers to risk that still present in all adequately diversified portfolios. The investor, therefore, seeks to eliminate the diversifiable risk by adding more assets to the portfolio.
a) A substantial, unexpected increase in inflation is a non-diversifiable risk. This is because a substantial, unexpected increase in inflation will affect all assets that an investor can invest in. Therefore, the risk cannot be eliminated by adding more assets to the portfolio.
b) A major recession in the U.S is a non-diversifiable risk. This is because, a major recession in the U.S will affect all assets that an investor can invest in the U.S. Therefore; the risk cannot be eliminated by adding more assets to the portfolio. However, if the investor is an international investor, the investor can eliminate the risk by adding more offshore assets to the portfolio. In such a case, a major recession in the U.S will be diversifiable risk.
c) A lawsuit is filed against a single large publicly traded company is a diversifiable risk. This is because a lawsuit is filed against a single large publicly traded corporation will affect only one assets that an investor can invest in. Therefore, the risk cannot be eliminated by diversifying the portfolio.
Beta will be half the stock exchange’s beta. Beta is a measure of risks that cannot be eliminated by diversification. Therefore, if one owned half the assets of a major exchange, then, beta will be half the risks that cannot be eliminated by diversification in that exchange.
The Capital Asset Pricing Model (CAPM) shows the relationship between required rate of return on assets and risks when the assets are held in well-diversified portfolios. CAPM assumes investors are rational, and they choose alternate portfolios based on each portfolio’s standard deviation and expected return. The expected return found using Capital Asset Pricing Model assumes that all the risks that can be eliminated by diversification have been eliminated. Therefore, the resultant expected return only contains an allowance for risks that cannot be eliminated through diversification.
The Capital Asset Pricing Model indicates to corporations the least rate of return they can borrow from investors. This is because CAPM gives the rate of return investors expect if they held an efficient portfolio. While making investment decisions, investors consider the opportunity cost. Therefore, corporation must compensate an investor an equal or a higher return to entice them to purchase the corporation’s financial asset.
The Capital Asset Pricing Model indicates to investors the returns to expect if they held an efficient portfolio. That is, a portfolio that has completely eliminated all risks that can be eliminated through diversification. It therefore indicates to investors the returns they should expect if they hold an efficient portfolio.
Equity financing refers to raising finances from the public by selling ordinary shares to the existing and potential shareholders. It is a permanent source of finance as shareholder cannot recall this capital unless and until the company is placed under liquidation. Debt finance is a source of finance that has a fixed return as its cost is fixed on the par value of the debt. It is raised from external sources by qualifying companies, and it is available in limited quantities. This paper discusses the advantages and disadvantages that will accrue to AMSC if it forgoes its debt financing and take on equity financing.
There are several advantages that will accrue to AMSC if it forgoes its debt financing and take on equity financing. Firstly, equity shares do not have a maturity date; the corporation, therefore, does not have any liability for cash outflow that are associated with the redemption of equity shares. Equity financing is, therefore, a permanent source of capital which is available for a company’s use as long as the company continues to be a going concern. Secondly, issuing of equity shares raises the company's capital base and as a result its borrowing limit is increased since, debt is usually provides capital in proportion to the company’s equity. Unlike debt financing which increases the financial leverage of a firm thus reducing its ability to borrow in the future.
Another advantage is that corporations are not legally obliged to pay any dividend and, therefore, in during financial difficulties, equity financing can decrease or suspend paying common dividends. On the other hand, debt financing results in a legally binding obligation to pay interest and principal. Lastly, equity financing does not inflict any restrictions the company’s operation; therefore, it does not limit the operating flexibility of the firm in the future. In the other hand, debenture financing sometimes contains restrictive debt covenants which limits the flexibility in which the company carries out its operation in the future.
There are equally some disadvantages that will accrue to AMSC if it forgoes its debt financing and take on equity financing. . First of all, equity financing has a higher cost because; dividend is not tax deductable as debt interest is, floatation cost on equity are higher than on debt and common shares are more risky compared to debt instruments from the investors view point due to uncertainty regarding dividends and capital gains. Secondly, issuing new shares dilute the shareholder’s earnings per share. This is because earnings of the companies do not increase immediately in proportionality with the increase in the number of equity share. This will result in a drop in the share price of AMSC. Issuing new shares also dilutes ownership and control of existing shareholders. On the other hand, holders of debt instruments do not have voting rights and therefore, debt financing does not dilute ownership.
Another disadvantage of equity is that dividend paid to providers of equity finance varies with the level of earnings; therefore, they participate in extraordinary earnings of the company. On the other hand, debenture holders do not participate in extraordinary earnings of the company because their payment is limited to interest. Lastly, during periods of high inflation the company does not benefit if has equity financing. This is because dividend paid to providers of equity finance varies with the level of earnings. Whereas, during high inflation, a company with high debt financing benefits. This is because the company’s obligation of paying interest and principal, which remains fixed, decline in real terms.
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Ehrhardt, M. C., & Brigham, E. F. (2008). Corporate Finance: A Focused Approach (3, illustrated ed.). London: Cengage Learning.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (SAGE, 2007 ed.). New York: SAGE.