1. The CAPM computes expected rates of return on common equity capital using the following model:

E[REj] = E[RF] + j x {E[RM] E[RF]} What are the roles of each of the three components of this model?

2. Identify the types of firm-specific factors that increase a firms nondiversifiable risk (systematic risk). Identify the types of firm-specific factors that increase a firms diversifiable risk (idiosyncratic risk or nonsystematic risk).

3. Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable, financially healthy, profitable, tax-paying firm that has been financed with all equity and no debt decides to add a reasonable amount of debt to its capital structure. What effect will that change in capital structure likely have on the firms weighted average cost of capital?