Question

        6. (4 pts) Both Fun Corp. and Lovely Corp. are unlevered firms operating in a Perfect Capital Market.         

            The Total Volatility of returns for Fun Corp and Lovely Corp are equal.  

            Yet the Expected Return for Lovely Corp is greater than the Expected Return for Fun Corp.                                                                      

             BRIEFLY EXPLAIN why Lovely Corp stock may have a higher Expected Return even though the Total Risk of investing in either of these two firms is the same.

Answer 1

Solution:

The question says the risk (expressed as volatility) of both the firms is equal, yet the expected returns are not same.

This is due to the fact that expected returns are not solely dependent on risk. Risk primarily drives the required rate of return from a stock. Higher the risk higher would be the required rate of return and vice-versa.

However, expected rate of return is very different from required rate of return. While required rate of return is the cost of capital or the minimum rate of return that an investor wants from a stock, the expected rate of return is the actual return that the investors expect the stock will deliver.

When the expected return is equal to or higher than the required return, the stock should be bough and when expected return is lower than required return, the stock should not be bought.

If the risk of two stocks is same, it would mean that the required rate of returns from them would be same. However, the expected rate of return could be entirely different. this could be due to multiple factors such as industry's competitive scenario, competitive advantages, expected new projects, strategic edge of one company over other, etc.

Therefore, the similar risks of two firms would make their required return (i.e. minimum return required) same but the actual expected rate of return could be very different depending on which company's business is expected to perform better based on factors described above.