Question

You are looking at two companies, AB Electronics and YZ Electronics. Both operate in the same industry and have very similar operations. You estimate that AB Electronics has a volatility of 15% and a beta of 0.9. For YZ Electronics you estimate a volatility of 40% and a beta of 1.4. Which investment would carry more total risk? Which has more market risk? Calculate the equity cost of capital for both. Which company has the higher equity cost of capital?

The risk-free interest rate is 4% and the market expected return is 10%.

Answer 1

Beta indicates market risk whereas standard deviation indicate total risk.

So, YZ Electronics has both higher volatility as well as beta, so this stock carries more total risk as well as total market risk.

Equity Cost of capital can be calculated as:

Cost of Equity = Risk free rate + Beta * (Expected market return - Risk free rate) [CAPM Equation]

For AB Electronics, Cost of Equity = 4% + 0.9 * (10% - 4%) = 9.40%

For YZ Electronics, Cost of Equity = 4% + 1.4 * (10% - 4%) = 12.40%