a) Which ONE of the following statements underpins the rationale behind the CAPM method of estimating the cost of equity?

		Only unique risk is rewarded.
		Only market risk is rewarded as unique risk can be diversified away.
		Only unsystematic risk is rewarded as it cannot be diversified away.
		Only diversifiable risk is rewarded as it affects total risk.

b)

Which of the following statements are FALSE.

		Investors prefer diversified portfolios because they are less risky.
		Diversification with a large number of securities completely eliminates risk
		The risk of a well diversified portfolio depends on the unique risk of the individual stocks.
		For a well-diversified portfolio, only market risk matters

c) A firm has a beta of 0.8, the relevant market return is 12% and the risk free rate is 3%. What is the cost of equity for the firm? Express your answer as a percentage rounded to 2 decimal places, eg. 5.55.

Expert Solution

(a)correct statement is option (b)Only market risk is awarded as unique risk is diversified away.

Explanation:As per CA theory,unique or unsystematic or diversifiable risk is specifically related to a particular company and therefore they can be eliminated .

And market risk cannot be eliminated because that is the risk which affects all type of companies and not specifically related to a company

(b) Statements 2nd and 3rd are false.

Explanation:-

First statement is correct because when invested in diversified portfolios, variability reduces and hence they are less risky

Second statement is false because diversification only eliminates unique risk or company specific risk and not market risk .Therefore, it does not completely eliminate risk

Third statement is false because diversified portfolio eliminates and only market risk is there and hence it depends on market risk of individual assets and not unique risk of individual assets

Fourth statement is correct because as we have discussed above ,unique risk is eliminated and only market risk matters

(c) Cost of equity for firm =Risk free return + (market return-risk free return)*beta

=3+(12-3)*0.8=11.2%

jeff jeffy answered 2 years ago

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