Question

1. How has academic theory influenced investor behavior? 2. How does risk tolerance affect the type of portfolio a person should build? 3. Why are investors indifferent to the firm's capital structure? 4. With perfect capital markets, as a firm increases its leverage, how does its debt cost of capital change? Its equity cost of capital? lts weighted average cost of capital?

Answer 1

1) Academic theory has influenced investor behaviour by showcasing the theoretical framework in which to evaluate the free cash flow projections of a company and the fair value of a share. So if the discounted cash flow valuation techniques present a value of the share and if the stock of the company is below that level, then investors will flock to buy the stock till an equilibrium is reached. Similarly if the stock is overvalued, then selling would happen till it reaches the fair value as predicted by theoretical frameworks.

2) A high risk tolerance would mean that the protfolio would have high variance and also chances of high returns. While a low risk tolerance investor would build a diversified portfolio with a steady return and low volatility.

3) Investor's are in different to the capital structure of the firm as a leveraged structure would mean a higher return expectation. While for an all equity firm, the return expectation is lower than that of a highly leveraged firm but higher than that having optimal capital structure. So since the current share price of a firm reflects the reality of the cost of the capital related to the capital structure, the investors are not worried about capital structure as this information is already built in the price.

4) With increasing leverage, the cost of debt would increase. Also beyond a certain point, the cost of equity would also increase to reflect the higher chance of bankruptcy and associated costs. The weighted average cost of capital would decrease at first due to tax shields of debt and then would increase due to rising cost of debt and cost of equity.