Appendix a Discussion Questions 11A-1 How does the capital asset pricing model help explain changing costs of The capital asset pricing model explains the relationship between risk and return, and the price adjustment of capital assets to changes in risk and return As investors react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. As the prices of these securities adjust to investors' required returns, the company's cost of capital is adjusted accordingly 11A-2. How does the Sml react to changes in the rate of interest. changes in the rate of inflation, and changing investor expectations? The SML, Security Market Line, reflects the risk-return tradeoffs of securities As interest rates increase, the SMl moves up parallel to the old SML. Now investors require a higher minimum return on risk free assets and an equally higher rate for all levels of risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to provide the appropriate inflation premium and there is an upward shift in the sml In regard to changing investor expectations, as investors become more risk averse, the SML increases its slope. The more risk taken, the greater the return premium that is desired(see figure 11A-4) CopyrightC 2005 by The McGray-Hill Companies, Inc.Copyright © 2005 by The McGraw-Hill Companies, Inc. S-382 Appendix A Discussion Questions 11A-1. How does the capital asset pricing model help explain changing costs of capital? The capital asset pricing model explains the relationship between risk and return, and the price adjustment of capital assets to changes in risk and return. As investors react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. As the prices of these securities adjust to investors' required returns, the company's cost of capital is adjusted accordingly. 11A-2. How does the SML react to changes in the rate of interest, changes in the rate of inflation, and changing investor expectations? The SML, Security Market Line, reflects the risk-return tradeoffs of securities. As interest rates increase, the SML moves up parallel to the old SML. Now investors require a higher minimum return on risk free assets and an equally higher rate for all levels of risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to provide the appropriate inflation premium and there is an upward shift in the SML. In regard to changing investor expectations, as investors become more risk averse, the SML increases its slope. The more risk taken, the greater the return premium that is desired (see figure 11A-4)