Student Name: Akuzike Annabel Nguku

Student ID number: R2308D17016480

Module Name: Financial Management

Module Title Assessment Point: Summative Assignment 2

Assessment Task: Report

Module code: UU-MBA-710-MW-64980

Date: 16th June 2024

Table of Contents
QUESTION 1..................................................................................................................................3
QUESTION 2..................................................................................................................................3
QUESTION 3..................................................................................................................................3
QUESTION 4..................................................................................................................................3
References........................................................................................................................................6
QUESTION 1

QUESTION 2
Profitability
The profitability ratio assesses a company's capacity to create profit from its resources. The
Pecking Order Theory suggests that increasing company earnings lead to more internal cash,
reducing the need for debt. Profitable companies often reinvest the majority of their profits.
Companies with significant retained earnings will be able to support their investments. Internal
funding had a lesser risk than external finance. Companies with higher internal capital are less
likely to use debt. Sheikh and Wang (2011), Chen et al. (2014), and Murhadi (2011) found a
negative correlation between profitability and debt. According to Sheikh and Wang's (2011)
study, debt profitability is negatively impacted by the high cost of external finance. According to
Seftianne and Hand's (2011) research, debt profitability has a positive correlation. High profit
margins encourage creditors to lend to firms.
Size
According to (Kurniasari, I., Murhadi, W. R. & Utami,M., 2016) companies with a large size can
use more debt than smaller companies. The greater the assets owned, will enable the company to
obtain debt because the assets can be pledged as collateral for the debt. Research by Sheikh and
Wang (2011), Chen et al (2014), Murhadi (2011), and Seftianne & Hand (2011) suggests that
debt size has a good impact. According to Sheikh and Wang's (2011) research, the Trade-Off
Theory predicts a positive correlation between size and debt, as larger enterprises may
experience financial difficulties. Um's ( 2001) study also showed that, large corporations incur
lower supervision costs than small enterprises. Large corporations are more likely to employ debt
than smaller enterprises.
Asset Tangibility
Companies with more tangible assets are better positioned for loan performance. Lenders can
utilize tangible assets as collateral for loans. If a corporation fails to pay its obligations, creditors
can take the goods to settle the debt. Companies with high asset tangibility are less likely to
collapse and can take on more debt (Murhadi, W.R., 2011). According to Murhadi (2011),
issuing of debt secured by assets reduces asymmetric knowledge about financing costs. This is
consistent with Myers (1984). Information gaps between parties might lead to moral hazard
issues. Secured debt reduces asymmetric information, leading to a positive link between actual
assets and obligations. Sheikh Research & Wang (2011) found a negative correlation between
asset tangibility and debt. The Agency Theory suggests that the management leveraged the
company's fixed assets to get loans for a higher allowance than the collateral used.
Growth
High-growth companies often require external funding to support their expansion. Companies
with lower growth rates typically employ internal finance. Research by Sheikh and Wang (2011),
Chen et al. (2014), Murhadi (2011), and Seftianne & Hand (2011) shows a negative correlation
between debt increases. According to Murhadi (2011), high-growing enterprises provide a bigger
danger to income stability, which negatively impacts debt growth. Fluctuations in earnings might
discourage organizations from using excessive debt, especially if it is used to support a fixed
charge. According to Titman and Wessels (1988), the costs of an agency connection between
shareholders and bondholders are larger in rising businesses, indicating a negative correlation
between growth and debt. Chung (1993), Rajan, and Zingales (1995) discovered a negative
correlation between debt levels and economic development in industrialized nations.

Earnings Volatility
Chen and Jiang (2014) mentions that the work of poor management will increase earnings
volatility thus increasing the chances of financial failure, and this will result in companies
experiencing difficulties to obtain additional external funding (debt). Mahadwarta (2002)
reported earnings volatility often associated with the condition of instability or level of business
risk. Companies with high earnings volatility will lead to uncertainty about the outlook for the
future. The presence of high revenue volatility will increase the cost of bankruptcy. Bradley et al.
According to Mahadwarta (2002), more volatility in profits might lead to higher bankruptcy
costs for companies. As a result, management will utilize less debt. Sheikh and Wang (2011)
found a negative correlation between earnings volatility and debt. Creditors may avoid lending to
enterprises with substantial profit volatility, as it implies a high risk operation.

QUESTION 3

QUESTION 4
According to (FreshBooks, 2024) The Capital Asset Pricing Model (CAPM) is a financial theory
or equilibrium model used by investors. (Dhankar, R.S., 2019)Explains that it is used to describe
the connection between risk and return in a way that it explains why different securities have
different expected returns and it also provides a methodology for quantifying risk and translating
the risk into estimates of expected return on equity. (Dhankar, R.S., 2019) Further explains that
the CAPM explains that every investment carries two distinct risks. One is the risk of being in
the market, which is called systematic risk or beta, and the other is an unsystematic risk, which is
company-specific and can be diversified through the creation of portfolios. (FreshBooks, 2024)
Points out that a diversified portfolio helps to reduce systematic risk, whereas a non-diversified
portfolio increases it. (FreshBooks, 2024)Continues pointing out that by identifying these types
of risks, the CAPM formula was created. It was developed to measure systematic risk.
(FreshBooks, 2024)Believes that Sharpe found that the rate on an individual stock should be
equal its capital costs. The formula to determine this is the CAPM:
Ra = Rrf + βa (Rm – Rrf)
Where:
Ra is the expected return on a security
Rrf id the risk-free rate
Rm is the expected market return
Βa is the beta of the security
(Rm - Rrf) is the equity market premium
(Bajaj Finserv, 2024) Says that even though CAPM is a widely used tool in finance, it’s important
to recognize its limitations which are:
 Single-factor model, it relies on a single systematic risk factor which is beta to explain
asset returns and it doesn’t account for additional factors that may influence returns, such
as liquidity risk, credit risk. This simplicity may oversimplify the complexity of real-
world markets.
 Ignores transaction costs and taxes, the model doesn’t account for transaction costs
associated with buying and selling assets or taxes on capital gains. In practice, these costs
can significantly impact an investor’s actual return
 Static beta, CAPM assumes that an asset’s beta remains constant over time while in
reality, beta can fluctuate due to changes in a company’s business operations, market
conditions, or other factors. This can lead to inaccurate estimations of expected returns.
(Bajaj Finserv, 2024) Also argues that the CAPM offer some benefits to investors which are:

 Facilitating portfolio management, in a way that it allows investors to optimize their

portfolios by selecting a mix of assets that collectively align with their risk tolerance and
return objectives. The model helps in constructing well-diversified portfolios that balance
risk and returns.
 Setting a benchmark for expected returns. Trying to say that by providing a method to
estimate the expected return on an investment, CAPM establishes a benchmark against
which investors can compare the potential return of a particular asset. This comparison
assists in evaluating whether the expected return justifies the level of risks associated
with the investment.
According to (Czekierda, B., 2007) CAPM has assumptions which relate to how markets behave
and how investors make decisions. Below are the CAPM assumptions:
 Investors are risk-averse utility maximizers selecting portfolios on the basis of expected
return and variance (Czekierda, B., 2007), trying to say that model assumes investors can
accept to take the risk or decline. Therefore the CAPM requires the investors to gain a
diversified way of looking at risk portfolios. An investor may consider dividing the
investment between distinct assets, which attracts different risks and reactions towards
the circumstances (Team, 2022)
 Investors are price-takers and have homogenous expectations about asset returns that
have a joint normal distribution (Czekierda, B., 2007). This assumption makes apparent
the fact that it suggests that all investors, given the same amount of information, will
have the same expectations for future security prices, expected returns, and risk levels.
This means essentially that every investor will interpret and utilize the available market
information identically to form their expectations and strategies. This introduces a level
of simplicity into the calculation and determination of asset prices and market
performance (Study Smarter, n.d.).
 There exists a risk-free asset such that investors may borrow or lend unlimited amounts at
the risk-free rate (Czekierda, B., 2007). Since this assumption is held an individual
investor can allocate his capital in the risk-free asset and expect from such allocation
some predetermined return measured by interest rate. If investor is willing to allocate
more funds then he owns in the portfolio of risky assets, he is allowed to borrow money
at the same risk-free interest rate. Short-selling of the assets could be considered as
borrowing mechanism (Mukhacheva, G., 2012).
 There are no market imperfections such as taxes, regulations, or restrictions on short
selling (Czekierda, B., 2007). This assumption means that all securities are valued
correctly and that their returns will plot on to the Security Market Line (SML). A perfect
capital market requires the following: that there are no taxes or transaction costs; that
perfect information is freely available to all investors who, as a result, have the same
expectations; that all investors are risk averse, rational and desire to maximize their own
utility; and that there are a large number of buyers and sellers in the market (ACCA
Global, n.d.).
 Assets markets are frictionless, and information is freely available to all investors
(Czekierda, B., 2007). This simply means that the model assumes that investors have free
access to information before deciding on where to invest. When investors have access to
vital information, they may find the market efficient because having access to
information allows them to make sound investment decisions (Team, 2022).

References
ACCA Global. (n.d.). CAPM: theory, advantages, and disadvantages. Retrieved from ACCA
Global:
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Bajaj Finserv. (2024, May 15). Capita Asset Pricing Model (CAPM). Retrieved from Bajaj
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Chen et al. (2014). What Determine Firm’s Capital Strukture in China? Journal of Managerial
Finance, 40(10), 1024-1039.
Chen,J., Jiang.C. & Lin.Y. (2014). What Determine Firm’s Capital Strukture in China? Journal
of Managerial Finance, 40(10), 1024-1039.
Chung, K.H. (1993). Asset characteristics and corporate debt policy: an empirical test. Journal
of Business Finance and Accounting, 83-98.
Czekierda, B. (2007). The Capital Asset Pricing ModelTest of the model on the Warsaw Stock
Exchange (Dissertation). Retrieved from DiVA portal:
[Link]
Dhankar, R.S. (2019). Risk-Return Relationship and Portfolio Management. Springer India.
FreshBooks. (2024, March 15). Explaining CAPM Model (Capital Asset Pricing Model).
Retrieved from FreshBooks: [Link]
model
Kurniasari, I., Murhadi, W. R. & Utami,M. (2016). ANALYSIS OF FACTORS AFFECTING
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Rajan R.G., & Zingales L. (1995). What do we know about Capital Structure? Some evidence
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Team, I. E. (2022, July 9). What is the CAPM? (With assumptions and applications). Retrieved
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