(a) Total investment risk can be broken down into two types of risk. What are these...

(a) Total investment risk can be broken down into two types of risk. What are these two types of risk and which should NOT affect expected return? (b) A firm has a beta of 1.2. The expected market return is 12% and the risk-free rate is 2%. What should be the firm’s equity cost of capital?

Expert Solution

Total investment risk can be broadly classified into two:

Systematic risk and
Unsystematic risk.

Systematic risk is the risk commonly applicable to the entire market, across industries and companies. Such risks cannot be controlled through diversification. They can also not be hedged. A typical example is the possible impact on stock prices due to changes in laws or taxation related to stock market operations.

Unsystematic risk is the risk involved with respect to a particular stock or portfolio or industry alone. Such risks are controllable through diversification.

Unsystematic risk does not affect expected return as per CAPM theory.

Equity cost of capital is the expected or required rate of return from the stock. As per CAPM,

Expected return R_e= R_f + β(R_m-R_f)

Where R_f= Rate of return on risk free asset, β =beta coefficient and R_m= Market return.

Given

Beta=1.2, market return R_m= 12% and Risk free rate R_f= 2%

Substituting these values in the formula,

Expected return= 2% + 1.2*(12%-2%) = 2% + 1.2*10% = 2% + 12% = 14%

Therefore, Equity cost of capital= 14%

jeff jeffy answered 10 hours ago

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