Question

Polycom and Cisco are similar size competitors in the same industry. If the risk free rate is 4 percent, and the market portfolio is expected to pay 12 percent, what is the expected return on each stock if Polycom’s beta is 1.50 and Cisco’s beta is 0.95?

What might explain the differences in the two betas?

Answer 1

Polycom:

Beta = Bp = 1.5, Risk-Free Rate = Rf = 4%, Market Return = Rm = 12 %

Expected Return = Rf + Bp x (Rm-Rf) = 4 + 1.5 x (12-4) = 16 %

Cisco:

Beta = Bc = 0.95, Risk-Free Rate = Rf = 4%, Market Return = Rm = 12 %

Expected Return = Rf + Bp x (Rm-Rf) = 4 + 0.95 x (12-4) = 11.6 %

The difference in beta can be explained by the different levels of risk faced by each firm with respect to the market. The beta is composed of the firm's business specific risk and financial leverage risk.Now, as both firms have similar sizes and function in the same industry, their level of business specific risk are almost similar. However, their betas can be different if they have different degrees of financial leverage risks.