Finance

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FNCE 10001 |
Assignment 1|
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Thomas Hu 586870|
8/12/2012|

Tutorial: Thursday 1:00pm-2:00pm|

Question 1
A risk premium is the difference in value between the expected return on a security and the interest rate on an alternative, “risk-free” investment both of the same maturity. An asset’s risk premium is a form of compensation for investors who are willing to take on the uncertainties associated with a risky investment. This is used to attract investors to purchase equity securities from a corporation by giving them the potential for a larger return than a riskless alternative such as depositing money in a bank. For instance, risk premium can be expressed as an interest rate that is paid on investments; the high-quality bonds of a well-established corporation, such as a bank, have very little risk of default and hence will pay a relatively low interest rate. Less established companies carry a greater uncertainty in profits and thus might be forced to include a higher interest on investments to attract investors. Therefore, the reason why investors demand a risk premium is to increase the expected value of an investment and compensate them for taking on the risks involved with investing in a company by introducing higher rates of interest for bonds with higher risk of default. Risky investment

Risky investment
Risk premium
Risk premium
Level of Risk
Expected Return
Level of Risk
Expected Return

Risk-free
Return
Risk-free
Return

Question 2
Part A
The bank will provide debt financing in the form of a loan. This means that the bank will likely lend her money with the promise that she will pay the money back to the lender, with an additional sum of money, in fixed payments at fixed intervals until maturity. The amount that she must pay will be the original sum of the loan (the principal) as well as an interest on her loan. Other characteristics of debt are that the bank has no interest in the future profits of the business and merely lend money and earn interest from the business, and that loans have a finite term. Investors will provide her with equity, meaning that they will essentially buy into her business and own a ‘slice’ of the company for the future. Investors who see potential in her company will finance her project in the form of cash or securities and she will offer a contractual right in owning part of her business. This means that investors will share in the potential future profits of the company through dividends, and the term for this investment is indefinite.

Part B
A major benefit of debt as opposed to equity is that the borrower does not have to sacrifice ownership interest in the company and has full control over the business’s operations. Equity essentially sells off part of a company’s ownership and this forces the borrower to direct the business in a manner that pleases all the shareholders. Another benefit of debt is that lenders are limited in the amount of money that the borrower is obliged to repay, as the lender does not receive any ownership shares in the business. This means that the borrower only needs to pay back a fixed amount of money compared to the potentially limitless amount of money she may need to pay investors if she had sold stock in order to finance growth if her business is successful. The disadvantages of debt include the fact that unlike equity, debt must be repaid in full at a fixed point in time. One of the benefits of equity is that there is no obligation for the business to repay the money it borrows; instead investors give money to the corporation in the hopes that they will be able to share the profits of the company. If there is no profit, the borrower is not required to pay the lender back for any invested securities.

Part C
I would recommend my friend to choose debt. The first reason is that her major concern for the business is that she does not wish to give up ownership rights of her firm and wants to ensure she can...
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