Which stock carries more total risk-market risk

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Suppose you estimate that eBay’s stock has a volatility of 30% and a beta of 1.45. A similar process for UPS yields a volatility of 35% and a beta of 0.79. Which stock carries more total risk? Which has more market risk? 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 eBay and UPS. Which company has a higher cost of equity capital? Solution Total risk is measured by volatility; therefore, UPS stock has more total risk than eBay. Systematic risk is measured by beta. eBay has a higher beta, so it has more market risk than UPS. Given eBay’s estimated beta of 1.45, we expect the price for eBay’s stock to move by 1.45% for every 1% move of the market. Therefore, eBay’s risk premium will be 1.45 times the risk premium of the market, and eBay’s equity cost of capital (from Eq. 12.1) is r EBAY = 3% + 1.45 * (8% - 3%) = 3% + 7.25% = 10.25% UPS has a lower beta of 0.79. The equity cost of capital for UPS is r UPS = 3% + 0.79 * (8% - 3%) = 3% + 3.95% = 6.95% Because market risk cannot be diversified, it is market risk that determines the cost of capital; thus eBay has a higher cost of equity capital than UPS, even though it is less volatile.

Reference no: EM131054586

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