QUESTION ONE (31 MARKS) Capital investment decisions involves allocating funds of the firm in the most effective manner to make sure that the returns are the best possible returns. Assessing projects as well as the allocation of the funds which depends on the project requirements and the expected utility are some of the most crucial financial decisions that finance manager must make. This may also partly be influenced by individual subjective preferences. If an individual risk preference meets certain conditions then the shape of the individual utility functions determines a measure of the risk aversion. An individual with decreasing relative risk aversion invest proportionally more in the risky asset as their wealth increases and the opposite is true. Required a) Explain the difference between ordinal utility and cardinal utility from an investor perspective (4 Marks) b) Briefly explain the following conditions i. Completeness (3 Marks) ii. Transitivity (3 Marks) iii. Continuity (3 Marks) iv. Independence (3 Marks) v. Dominance (3 Marks) b) Investment decision in a condition of uncertainty may contravene the presumption of rational investment decision, briefly explain the following terms i. Irrational optimism. (3 Marks) ii. Adverse selection. (3 Marks) c) Briefly highlight limitation of any three investment appraisal technique. (6 Marks) QUESTION TWO (23 MARKS) The efficient market hypothesis (EMH) is an investment theory that states that it is impossible to always make profit from the securities market. The market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, shares always trade at their fair value on securities exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert shares selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments. Required a) Explain the random walk theory (4 Marks) b) Explain the differences between technical analysis and fundamental analysis (6 Marks) c) Explain the different form of market efficiency (9 Marks) d) Explain the factors that causes the market shocks (4 Marks) QUESTION THREE (23 MARKS) Under capital assets pricing model (CAPM), an investor maximizes utility by only considering the expected return and variance. Required a) Explain meaning of efficient market portfolio (4 Marks) b) Outline the assumption underlying the CAPM theory (9 Marks) c) Considering the assumption of CAPM argue a case for Arbitrage pricing theory (10 Marks) QUESTION FOUR (23 MARKS) The dividend decision is one of the crucial decisions made by the finance manager relating to the payouts to the shareholders. The companies can pay either dividend to the shareholders or retain the earnings within the firm. The payout is the proportion of earning per share given to the shareholders in the form of dividends. The amount to be disbursed depends on the preference of the shareholders and the investment opportunities prevailing within the firm. If a firm pays dividend it affects the cash flow position of the firm but earns the goodwill among investors who therefore may be willing to provide additional funds for financing of investment plans of firm. Required a) Explain the signaling theory from dividend decision perspective (4 Marks) b) Explain the factor considered by management in making investment decision (8 Marks c) Explain the various theoretical preposition on how dividend affect the value of the firm (11 Marks) QUESTION FIVE (23 MARKS) Different combinations of risky assets produce different levels of return. The efficient frontier represents the best combinations of risky asset where the investor maximize the expected return for a given level of risk Required a) Using the concept of the efficient frontier, explain how the individual choice of optimal portfolio is determined by utility (4 Marks) b) Explain the concept of diminishing marginal utility and how it influences the investment decision (6 Marks) c) Briefly explain the three type of risk aversion (9 Marks) d) Using the typical case of live betting, explain the efficient frontier (4 Marks) QUESTION SIX (23 MARKS) The choice of capital structure matters to a company because it directly influences a company's ability to create shareholder value. The ration between equity and debts sets the minimum threshold for a company's cost of capital. Investments in the business must meet this threshold, or value is destroyed. Required a) Explain the concept of optimal capital structure (4 Marks) b) Explain the pecking order theory (3 Marks) c) Explain the relationship between the investment decision and financing decision (7 Marks) d) Explain the capital relevance and irrelevance theory (9 Marks)