A) The diversification in a portfolio is used to reduce risks in the overall stocks by lowering the correlations. For instance the coefficients that are measured range in a percentage such as 1 to 100 percent. If considering an investment a person may analyze a portfolio and utllize a point of emphasis in which they will consider such as 45%, a person will review the portfolio balances, names, correlation percentage, and correlation group.
B) Cost of debt capital is lower than cost of equity in almost every case. Also, the interest cost on debt is a tax deductible item which brings down the cost of debt. So, if the cost of debt is so low, why not finance the company with 100% debt? This wont work because of high interest costs and ultimate obligation to return the capital. When we are operating in higher debt levels , people lose the confidence on the company's ability to pay off its debts as it is huge. So along with interest cost comes along costs of distress such as; bankruptcy, reorganization, & restructuring costs. Such costs are called costs of financial distress. These costs are incurred when a company operates at more than optimal level of debt capital. Having high debt ratios do not mean that their cost will be less than equity cost as higher debt levels comes along with costs of financial distress.
A) Identify at least one type of firm that might exhibit low correlations of returns with the overall stock market?
B) There are multiple ways of measuring financial distress. Can you think of a way and develop the argument a bit further as to why equity might be used instead of 100% debt? please explain