You have a friend who claims that because Microsoft has a higher standard deviation than Exxon,...

You have a friend who claims that because Microsoft has a higher standard deviation than Exxon, it must have a higher cost of equity as well. Briefly explain why this is an incorrect statement.

Expert Solution

Here we will be using the concept of Capital asset pricing model which is having the BETA a systematic risk factor. The equation for expected return= risk-free rate= Beta* Risk premium. Since the stocks are traded on market we will have the risk premium which an investor expects an additional amount of return than the market.

Coming to the answer:

The reason they mentioned the statement as incorrect because for a person who is interested in finding the cost of equity investor will look at the beta value form the CAPM equation. The friend told that it is based on standard deviation which was wrong. The subject depends on the BETA factor which is a company assets risk and the standard deviation as the Total risk which will include the both Beta and unsystematic risk but here we are concerned about the firm.

For a company it is the cost of equity but for an investor it is the amount of return he is anticipating to acquire from the market. The friend will be correct when he/she speaks about the risk- reward ratio which we call it is as the

Sharpe ratio= Return- Risk-free rate / Standard deviation

I conclude that the friend is wrong using the STANDARD DEVIATION as a parameter.

Thank You.

jeff jeffy answered 2 years ago

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