The CAPM Equation for the Cost of Capital (using the Security Market Line).

The cost of capital of any investment opportunity equals the expected return of available investments with the same beta.

\[R_i = R_f + \beta \times (E[R_m] - R_f)\]

12.1 The Equity Cost of Capital

Problem

Suppose you estimate that Disney’s stock (DIS) has a volatility of 20% and a beta of 1.29. A similar process for Chipotle (CMG) yields a volatility of 30% and a beta of 0.55.

Which stock carries more total risk? Which has more market risk?

Disney has more Systematic risk.

Chipotle has more total risk.

12.1 The Equity Cost of Capital

Problem

Suppose you estimate that Disney’s stock (DIS) has a volatility of 20% and a beta of 1.29. A similar process for Chipotle (CMG) yields a volatility of 30% and a beta of 0.55.

If the risk-free interest rate is 3% and you estimate the market’s expected return to be 8%, calculate the equity cost of capital for DIS and CMG. Which company has a higher cost of equity capital?

Because market risk cannot be diversified, it is market risk that determines the cost of capital; thus DIS has a higher cost of equity capital than CMG, even though it is less volatile.

12.1 The Equity Cost of Capital

Suppose you estimate that Walmart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson & Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk?

Walmart stock has more total risk.

Johnson & Johnson has a higher beta, so it has more market risk

12.1 The Equity Cost of Capital

Suppose you estimate that Walmart’s stock has a volatility of 16.1% and a beta of 0.20. A similar process for Johnson & Johnson yields a volatility of 13.7% and a beta of 0.54. Which stock carries more total risk? Which has more market risk?

If the risk-free interest rate is 4% and you estimate the market’s expected return to be 12%, calculate the equity cost of capital for Walmart and Johnson & Johnson. Which company has a higher cost of equity capital?

\[r_{JNJ}=4\%+0.54×(12\%−4\%)=4\%+4.32\%=8.32\%\]

\[r_{WMT}=4\%+0.20×(12\%−4\%)=4\%+1.6\%=5.6\%\]

Because market risk cannot be diversified, it is market risk that determines the cost of capital; thus, Johnson & Johnson has a higher cost of equity capital than Walmart, even though it is less volatile.

12.2 The Market Portfolio

12.2 The Market Portfolio

To use the CAPM, we need to understand what the market portfolio is.

Because the market portfolio is the total supply of securities, the proportions of each security should correspond to the proportion of the total market that each security represents.

Thus, the market portfolio contains more of the largest stocks and less of the smallest stocks.

Market capitalization (of one firm):

The total market value of a firm’s outstanding shares