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Capital Investment Appraisal, Market Efficiency, CAPM, and Financial Reporting

Question 1

INSTRUCTIONS TO CANDIDATE:

1. Answer ALL questions.

2. Please clearly state the questions number IN THE ORDER you have answered them on the cover page of the answer sheet.

3. Each answer must be at least two and a half-page in length.

4. Each question should start on a new page.

5. Your answers should be presented in an essay format.

6. Please state your student number on every new page.

7. Please refer to the separate document published in the Blackboard for more specific instructions.

Question1: Consider the following projects:
Cash Flows (RM) 
Project C0 C1 C2 C3 C4 C5 
A -1000 +1000 0 0 0 0 
B -2000 +1000 +1000 +4000 +1000 +1000 
C -3000 +1000 +1000 0 +1000 +1000

(a) Calculate the following: i. NPV for each project if the opportunity cost of capital is 10%. ii. The payback period for each project. iii. The discounted payback period for each project. Critically evaluate which project would a firm accept based on the techniques of capital investment appraisal. (15 marks) (b)Critically evaluate the Internal rate of return as one of the investment appraisal methods. In addition, mention at least three (3) problems of the IRR method.

Question 2: (a) Critically evaluate the differences between the three forms of market efficiency (weak, semi-strong and strong form)and discuss the key developments of relevant theory since the introduction of FAMA in the 1970s. (15 marks) (b) What are the implications for the efficient markets hypothesis if it is possible to earn abnormal returns by trading based on positive correlations in returns? Justify your answer. (15 marks)

Question 3: Identify and critically evaluate the concept and the underlying assumptions of the capital asset pricing model (CAPM). (25 marks)

Question 4: In a perfect world, investors, board members, and executives would have full confidence in companies’ financial statements. They could rely on the numbers to make intelligent estimates of the magnitude, timing, and uncertainty of future cash flows and to judge whether the resulting estimate of value was fairly represented in the current stock price. And they could make wise decisions about whether to invest in or acquire a company, thus promoting the efficient allocation of capital.

Unfortunately, that’s not what happens in the real world, for several reasons. First, corporate financial statements necessarily depend on estimates and judgment calls that can be widely off the mark, even when made in good faith. Second, standard financial metrics intended to enable comparisons between companies may not be the most accurate way to judge the value of any particular company - this is especially the case for innovative firms in fast-moving economies - giving rise to unofficial measures that come with their own problems. Finally, managers and executives routinely encounter strong incentives to deliberately inject error into financial statements.

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