Question

		Beta	Risk of return	Market rate of return	Resonable return
	Las Vegas Sands Corp (LVS)	1.72	1.50%	6.75%	10.53%
	Tiffany (TIF)	1.77	1.50%	6.75%	10.79%
	Sonic Corp (SONS)	1.55	1.50%	6.75%	9.64%

		Beta	Risk free rate of return	Market rate of return	Reasonable return
	Walmart (WMT)	0.57	1.50%	6.75%	4.49%
	Starbucks (SBUX)	0.66	1.50%	6.75%	4.97%
	McDonald's (MCD)	0.65	1.50%	6.75%	4.91%

1.What do you notice about the pattern or trend of required returns for companies in #1 as compared to those of the companies in #2? Why does that occur?

2. Note “company c” in each group. They would generally be considered competitors in the same business, yet one is in the first group and the other in the second. Which type of risk (market, specific) do you think is at work here? Consult the resources for this week carefully – the answer is in there – don’t guess. Explain briefly.

  

Answer 1

Answer 1: The required returns for companies in #1 are greater than the market return whereas the required returns for companies in #2 are less than the market rate of return.

This is because the returns are calculated based on the Capital Asset Pricing Model which is as follows:

Required Return = risk free rate of return + Beta * (Market Return - Risk Free Rate of Return)

All the other variables in the above expression are related to the market, except Beta, which is unique to each firm. Beta provides a measure of sensitivity/volatility of the returns on the company stock price to the market returns.

The companies in #1 are more sensitive (more upside) to the change in market returns than companies in #2.

Answer 2: The grouping over here is again based on Beta. i,e. company C in #1 responds more to upswing in the market returns (similar to other companies in #1) than the company C in group #2 which has Beta <1 . This is because Beta is a measure of systematic risk/market risk which is undiversifiable. It is essentially a measure of the risk arising from exposure to general market movements and not specific factors.