Question

Aluminum maker Alcoa has a beta of about 1.88 , whereas Hormel Foods has a beta of 1.01. If the expected excess return of the market portfolio is 6%, which of these firms has a higher equity cost of capital, and how much higher is it?

Answer 1

Alcoa, with a beta of 1.88, has a higher equity cost of capital at 11.28%, which is 5.22% higher than Hormel Foods' equity cost of capital, calculated with a beta of 1.01 to be 6.06% using the CAPM formula.

Step-by-step explanation:

The equity cost of capital for a firm is calculated using the Capital Asset Pricing Model (CAPM), which takes into account the beta of the stock. The equation is given as:

Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)

The Market Risk Premium is generally considered as the difference between the expected market return and the risk-free rate. In this case, the expected excess return given for the market portfolio is 6%.

Therefore, for Alcoa with a beta of 1.88, its equity cost of capital would be higher because the CAPM formula implies a higher rate for a higher beta, assuming the risk-free rate is constant.

Consequently, Alcoa's cost of equity would be 6% + 1.88 × 6% = 11.28%.

On the other hand, for Hormel Foods with a beta of 1.01, its equity cost of capital will be 6% + 1.01 × 6% = 6.06%.

The difference between the equity cost of capital for Alcoa and Hormel Foods is then 11.28% - 6.06% = 5.22%.