Question

Aluminum maker Alcoa has a beta of about 2.00​, whereas Hormel Foods has a beta of 0.45. If the expected excess return of the market portfolio is 5 %​, which of these firms has a higher equity cost of​ capital, and how much higher is​ it?​

Answer 1

Answer:

Part A:

Alcoa has higher expected return hence has a higher equity cost of capital.

Part B:

Capital cost higher=0.0775=7.75% higher

Explanation:

Part A:

Those stocks whose beta is higher has higher expected return because the risk is higher in these stocks. Since Alcoa has beta value value of 2.00 which is higher than Hormel foods having beta 0.45, it means Alcoa has higher expected return hence has a higher equity cost of capital.

Part B:

Difference in beta= Beta of Alcoa-Beta of Hormel

Difference in beta=2-0.45

Difference in beta=1.55

Capital cost higher=Difference in beta*Excess return

Capital cost higher=1.55*5%

Capital cost higher=1.55*0.05

Capital cost higher=0.0775=7.75% higher

Explanation:

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Answer 2

Answer:

CAPM:

The CAPM is a model to predict expected return on a stock given the amount of market risk that the stock carries. The market risk is the risk of the broad market index and is measured by Beta.Alcoa will have a higher return due to greater market risk in form of a greater Beta.

The difference in the cost of capital is: