Question

Ford is considering purchasing Tesla. It would cost $120 billion. Tesla has a beta of 2.15 and standard deviation of 17.15%. The expected return from purchasing the company is 14.67%.

Prepare a statement to the executive committee with a recommendation to proceed or not. Be sure to address the following items:

1. Define beta and standard deviation in relation to the measures of risk they represent.
2. Address the risk-return tradeoff.
3. Incorporate Ford’s current financial position and cost of capital.

Answer 1

Answer 1. : Beta represents the volatility in the particular stock relative to the market as a whole whereas standard deviation measures the risk of individual stock price. In more simple way beta is the volatility in the stock relative to the market and standard deviation is for risk in the particular stock.

Answer 2: Risk-return trade off is a concept under which  the amount return gain on an investment is depends on the risk undertaken on that investment, for higher return higher risk must be undertaken.

Answer 3: On the basis of the above given data Tesla stock's nature has higher volatility because it's a beta is more than 1 at 2.15 and higher standard deviation also shows that risk in Tesla is quite higher in long term. But concept of risk return trade off is fully applicable here expected rate of return is higher at 14.67% .

For calculating the cost of capital we assume market risk premium 5% and risk free return rate 3%

then cost of capital = risk free rate of return + beta of the stock x (market risk premium - risk free rate)

= 3% + 2.15 (5% - 3%)

= 3% + 2.15 * 2% = 7.30%

while seeing the expected rate of return is good in comparison with cost of capital.