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What is meant by the term Most investors are risk averse?

Ans: Most investors are indeed risk averse and certainly the average investor is risk
averse, at least with regard to his serious money. Risk averse investor have higher
required rates of return for higher risk securities.
Q. What are the implication of risk aversion for security prices and rates of return?
Ans: Other things held constant the higher a security risk the lower its price and the
higher its required return.
Q. What is risk premium?
Ans: Risk premium represents the compensation investors require for assuming the
additional risk. RP is the difference between the expected rate of return on given risky
asset and that on a less risky asset.
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Q. Define cost of capital?
Ans: A companys cost of capital is the average rate of return required by investors in the
companys securities. This average rate is used as a minimum acceptable rate of return for
new investments being considered by the firm.
Q. Why is the after tax cost of debt used to calculate the weighted average cost of capital?
Ans: The reason for using the after tax cost of debt is as follows- The value of the firms
stock which we want to maximize depends on after tax cash flows. Because interest is a
tax deductible expense, it produces tax savings which reduce the net cost of debt, so the
after tax cost of debt is less than the before tax cost. We are concerned with after tax cash
flows and since cash flows and rates of return should be on a comparable basis, we adjust
the interest rate downward to lake account of the preferential tax treatment of debt.
Q. What is cost of preferred stock(kp)?
Ans: Cost of preferred stock is the rate of return investors require on the firms preferred
stock.
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Q. What is bond?
Ans: A bond is a debt or long term promissory note, issued by the borrower, promising to
pay its holder a predetermined and fixed amount of interest per year.
Q. What is market value of a bond?
Ans: The market value of a bond is the discounted value of the dollar payments promised
to the bond holder using the market interest rate to discount those payments.
Q. What is per value?
Ans: The dons face value that is returned to the bondholder at maturity.
Q. What is Coupon interest rate?

Ans: The coupon interest rate on a bond indicates the percentage of the per value of the
bond that will be paid out annually in the form of interest.
Q. What is Maturity?
Ans: The maturity of a bond indicates the length of time until the bond issuer return the
per value to the bondholder and terminates or redeems the bond.
Q. What is Indenture?
Ans: An indenture is the legal agreement between the firm issuing the bonds and the bond
trustee who represents the bondholders. The indenture provides the specific terms of the
loan agreement and the responsibilities of the trustee.
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Q. Define Financial structure and Capital structure
Ans: Financial structure: The mix of all funds sources that appear on the right-hand side
of the balance sheet is called financial structure. Financial structure of a firm divide its
total fund sources between short and long term components.
Capital structure: Capital structure represents the mix of long term sources of funds used
by the firm. In equation form capital structure= Financial structure- Current liabilities.
Q. What is the objective of a capital structure management?
Ans: The objective of capital structure management is to mix the permanent sources of
funds used by the firm in a manner that will maximize the companys common stock
price. Alternatively, this objective may be viewed as a search for the fund mix that will
maximize the firms composite cost of capital. We can call this mix of funds sources the
optimal capital structure.
Q. Identify some important factors affecting capital structure decision of a firm.
Ans: The first is the firms business risk. The greater the firms business risk, the lower its
optimal debt ratio.
The second key factor is the firms tax position. If much of a firms income is already
sheltered from taxes by accelerated depreciation or tax loss carryovers from previous
years, its tax rate will be low, and debt will not be as advantageous as it would be to a
firm with a higher effective tax rate.
The third important consideration is financial flexibility. The potential future availability
of funds the consequences of a funds shortage have a major influence on the target capital
structure.
The fourth debt-determining factor has to do with managerial attitude with regard to
borrowing.
Q. Is capital structure policy a trade off between risk and return?
Ans: Capital structure policy involves a trade-off between risk and return. Using more
debt raises the riskiness of the firms earnings, but a higher proportion of debt generally
leads to a higher expected rate of return. Higher risk associated with greater debt tends to
lower the stocks price, but the higher expected rate of return raises it. The optimal capital
structure is the one that strikes a balance between risk and return and thereby maximize
the price of the stock.

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Q. What is dividend policy ? Optimal dividend policy?
Ans: Dividend policy involves the decision to payout earnings or to retain them for
reinvestment in the firm.
If the firm adopts a policy of paying out more cash dividends, which will tend to
increase the price of the stock. However if cash dividends are increased then less money
will be available for reinvestment. The expected future growth rate will be lowered and
this will depress the price of the stock. The optimal dividend policy for a firm is to
balance between current dividends and future growth which maximizes the price of the
stock.
Q. Define stock split and stock dividend.
Ans: An action taken by a firm to increase the number of share outstanding is stock split.
For example doubling the number of shares outstanding by giving each stockholder two
new shares for each one formerly held.
When dividend is paid by the firm in the form of additional shares of stock rather than in
cash is called stock dividend. On a 5% stock dividend, the holder of 100 shares would
receive on additional 5shares without cost.