Investment and Equity Cost

2. Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft’s stock has a volatility of 30%.

A. Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is higher than 10%?

No, Microsoft is diversifiable and it will not be affected by the changes in the market. We do not expect Microsoft’s equity cost of capital to be higher than 10%. Each stock carries its own weight.

B.What would have to be true for Microsoft’s equity cost of capital to be equal to 10%?

In order for Microsoft’s equity cost of capital to be 10% its beta will have to be 1. 4. Suppose all possible investment opportunities in the world are limited to the five stocks listed in the table below.

What does the market portfolio consist of (what are the portfolio weights)?

Stock Price/Share ($) Number of Shares Outstanding (millions) A 10 10 B 20 12 C 8 3 D 50 1 E 45 20

Total value of the market = 10×10+20×12+8×3+50×1+45×20= $1. 314 billion
Stock Portfolio Weight A 10×10=100 100/1314 =0. 0761 x 100 = 7. 61%
B 20×12= 240 240/1314 =0. 1826 x 100= 18. 6%
C 8×3= 24 24/1314= 0. 0183 x 100 = 1. 83%
D 50x 1 = 50 50/1314=0. 03381 x 100 = 3. 81%
E 45×20 = 900 900/1314= 0. 6859 x 100 = 68. 49%
Total = 100% 5.

Using the data in Problem 4, suppose you are holding a market portfolio, and have invested $12,000 in Stock C.
A. How much have you invested in Stock A? 12,000x(10×10)/(8×3)=$50,000

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