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Principles of Finance

Question 1

First scenario

There's a substantial unexpected increase in inflation.

Diversification is a situation whereby the investor contributes to different projects so that if one project fails than the income from other projects will boost him and also finance the expenses of the failing project. Inflation involves a rapid increase in prices of basic goods and services which results in the currency’s value decreasing. In this scenario it’s not possible to avoid the risk of inflation. The scenario thus involves a non-diversifiable risk, (Berezin, 2005).

Second scenario

There's a major recession in the U.S.

As discussed above, diversifiable risks are risks that can be mitigated by operating different projects to avoid overall loss. By doing this the investor is going to be making profits from other projects even if one project is making a loss. Recession is a period in business cycle that is characterized by a fall in the economic activities of a country. Recession affects everyone in the economy and thus all the projects, even if diversified will be affected. As a result, it will bring about a non-diversifiable risk, (Black, 1972).

Third scenario

A major lawsuit is filed against one large publicly traded corporation

A lawsuit is a case presented to a court of law by the plaintiff claiming that he/she has incurred some damages as a result of the actions of the defendant. In this scenario the case is affecting the defendant’s one corporation only. As discussed earlier diversification is the act of operating many projects as an investor to avoid or to reduce the risk of loss. Diversifiable risk is the one that can be mitigated by this act of operating many projects. In this scenario the owners of the corporation can start another business and it will not be affected by the risk. In case they are operating other businesses already, then the income of those businesses will be used in the case of that corporation. It is thus clear that the scenario will bring about a diversifiable risk.

Question 2

Capital assets pricing model

The investors need to know the expected return and the risk involved in a certain project before investing in it and thus capital assets pricing model is used for that. It shows the relationship between expected return and risk. The formula used is:

Er= RF +β (rm – RF)


Er is the expected return

RF is the risk free rate of return

Β is the beta of the security

Rm is the expected market return.

Part a

Asset i

0.12= 0.04+1.2(rm-0.04)






Part b

Asset j

0.09= rf+0.8(0.1-rf)






Portfolio return of asset I and j will be given by:

(0.5×0.12) + (0.5×0.09)=0.105= 10.5%

Portfolio beta is given by:

(0.5×1.2) + (0.5×0.8) =1

The portfolio beta of assets I and j is 1.

A beta of 1 in any portfolio indicates that the securities’ price will move with the market and thus in this case the prices of asset I and j will move with the market since they have a beta of 1.

Question 3

As discussed above, the capital assets and pricing model is a very important tool to both corporations and investors. Corporations for instance float their shares in the stock exchanges in order for them to raise capital from the public. They use the capital in their corporations. On the other hand, investors purchase shares floated in the stock exchanges by the corporations, speculating that the prices of the shares will go up and thus they then see the shares and hence make profits.

On the part of the corporations they use the capital collected from the public to invest in various projects or in one project. They thus need capital assets and pricing model to evaluate which project is the best to invest in on the basis of the risk involved and the expected return on the projects. On the side of the investors they need to speculate wisely in order for them to make profits in the stock or asset invested in. They thus need to know the risk and the expected return on the stocks they are investing in. As a result, they use capital assets pricing model for that (Rubinstein, 2006).

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