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    Diversifiable or Undiversifiable Risk: Using CAPM

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    Part I
    1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
    a. There's a substantial unexpected increase in inflation.
    b. There's a major recession in the U.S.
    c. A major lawsuit is filed against one large publicly traded corporation.
    2. Use the CAPM to answer the following questions:
    a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
    b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
    c. What do you think the Beta (?) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
    3. In one page explain what you think is the main 'message' of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?
    Part II:
    American Superconductor
    As you know from reading through the background materials, the decision to use debt or equity to raise money is not a decision taken lightly by management. So when several years ago, in 2003 American Superconductor decided to raise funds through equity it was definitely a major decision that required intense discussions at the highest levels of management.
    Read the article below about American Superconductor and do some of your own research using the CyberLibrary and internet search engines. You can also take a look at the official American Superconductor webpage.
    After doing your research, apply what you learned from the background materials and write a two to three page paper answering the following questions:
    What are the advantages and disadvantages for AMSC to forgo their debt financing and take on equity financing? Do you agree with their decision? How can a company's cost of equity be determined? Is there a tax deduction from the use of debt financing? Please explain.
    Help me Explain both of your answers thoroughly. Be sure to support your opinions on these assignment questions with references to the background materials or to other articles in your paper.
    American Superconductor switch ; Westboro company plans to raise money through a stock offering
    Andi Esposito. Telegram & Gazette. Worcester, Mass.: Aug 26, 2003. pg. E.1
    Abstract (Article Summary)
    "AMSC's management and board of directors believe the decision to forgo a secured debt financing and to adopt an equity financing strategy under current market conditions is in the best interests of our shareholders," said Gregory J. Yurek, chief executive officer of AMSC. The 265-employee company has operations in Westboro and Devens and in Wisconsin.
    Finally, the Northeast blackout "shined a lot of light on the problems we have been talking about as a company for three to four years," Mr. Yurek said. AMSC products, such as a system installed this year in the aging Connecticut grid and high temperature superconductor power cables and other devices bought by China for its grid, are designed to improve the cost, efficiency and reliability of systems that generate, deliver and use electric power. "We are a company with products out there solving problems today," he said.

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    Solution Preview

    See the attached file.

    1. Whether or not the scenario represents a diversifiable or an undiversifiable risk
    a) Substantial unexpected increase in inflation is undiversifiable risk as inflation it is a phenomenon which impacts all investment options in the markets, and not one particular stock, in a manner that diversification in investment in different securities won't be able to remove this risk. Though in most cases rises in inflation in a country tends to spread to other countries through financial market system, there are some ways that can be used to reduce the inflation risk such as through investment in property or commodity markets or investing in securities in foreign financial markets not impacted inflation in (Thought Capital, 2011).
    b) Major Recession in the US would be seen as an undiversified risk since this recession would impact all securities and investment options within the U.S. financial market. But in the real sense just like Inflation, recession can though be diversified through foreign stocks and currencies, and the commodity market which would hedge an investment portfolio against a recession (Thought Capital, 2011).
    c) Major lawsuit filed against one large publicly traded corporation is viewed as a diversified risk since the law suit will only impact the corporations stock in the market adversely. In essence an investor can diversify their investment portfolio by buying in other asset classes or other companies' stock thereby leveraging their investment portfolio against such occurrences in one of the stocks invested in due to major law suit of the stock's corporation (Thought Capital, 2011).

    2. Capital Asset Pricing Model (CAPM)
    a) Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2, is:
    Using CAPM formula, Ri = Rf + ?i (Rm-Rf), then the substituting the above values to find the Expected Rate of Return on the Market Portfolio (Rm); 0.12 = 0.04 + 1.2(Rm - 0.04)
    0.12 = 0.04 + 1.2Rm - 0.048;
    0.12 = 1.2Rm - 0.008
    0.128 = 1.2Rm; Rm = 0.128 / 1.2
    Rm = 0.10667 or 10.67%
    b) The Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8, is:
    Using CAPM formula, Rj = Rf + ?j (Rm-Rf), then the substituting the above values to find the Risk-Free Rate (Rf); 0.09 = Rf + 0.8(0.1 - Rf)
    0.09 = Rf + 0.08 - ...

    Solution Summary

    The solution explains for each scenario is it represents a diversifiable or undiversifiable risk. It also uses CAPM to answer given questions.

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