Question

P338 - Inco 4-Show your work to get credit. Nam - 1. Pond of liwhile Coca Cola's 03. You expect the volatility of Pond to be 2016 od that of Coca Cola to be 30% over the next year. (a) Which company has a higher total risk and which coolers the Wigher expected returned on CAPM Explain (b) Which company is rinkiest for a diversified investor and an undiversified investor? Explain. each 2. ll Lilly has of 0.51, a forward dividend per share of $2.58, and you expect it to grow in perpetuity lwy year. Suppose the expected return on the S&P 500 is 11% and the risk-free rate is 2.5% (a) What should be the stock price of Eli Lilly according to the CAPM? (b) If the market price of Eli Lilly is $124.31, would you buy or sell the stock? Explain.

Answer 1

1]

(a)

Total risk = systematic risk + unsystematic risk.

Total risk is measured by standard deviation of the stock.

Systematic risk is measured by beta of the stock.

Coca-Cola has higher total risk as it has a higher standard deviation.

CAPM expected return = risk free rate + (beta * market risk premium).

Risk free rate and market risk premium are the same for all stocks in the market.

Therefore, the stock with higher beta will have a higher expected return.

Ford has a higher expected return as it has a higher beta.

(b)

For a diversified investor, the systematic risk as measured by beta will be 1. This is because unsystematic risk is eliminated by diversification. Ford is more risky for the diversified investor because if the stock of Ford is added to their portfolio, the overall portfolio beta will increase (since the beta of Ford is more than 1).

For the undiversified investor, Coca-Cola is more risky because Coca-Cola has higher total risk due to higher unsystematic risk. Adding Coca-Coal to the portfolio of an undiversified investor will increase the total risk of the investor's portfolio.