Question

Aluminum maker Alcoa has a beta of about 1.96​, whereas Hormel Foods has a beta of 0.47. If the expected excess return of the market portfolio is 3​%. What is the equity cost of capital for each? Which of these firms has a higher equity cost of​ capital, and how much higher is​ it?

Answer 1

Alcoa's equity cost of capital is 5.88%, while Hormel Foods' is 1.41%. Alcoa has a higher equity cost of capital by 4.47%.

Step-by-step explanation:

The question is asking for the equity cost of capital for Aluminum maker Alcoa and Hormel Foods, given their respective betas and the expected excess return of the market portfolio. The equity cost of capital can be calculated using the Capital Asset Pricing Model (CAPM), which is represented by the formula: Equity Cost of Capital = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) Assuming the risk-free rate is not provided, we typically consider it to be close to zero in a low interest rate environment. Therefore, for Alcoa with a beta of 1.96, its equity cost of capital would be approximately 0% + 1.96 * 3% = 5.88%. For Hormel Foods with a beta of 0.47, its equity cost of capital would be approximately 0% + 0.47 * 3% = 1.41%. Alcoa has a higher equity cost of capital than Hormel Foods, and it is higher by the difference between the two calculations, which is 5.88% - 1.41% = 4.47%.