Treasury Bill rate: 0.34 Market Yield: 8%
0.34 + [ 0.87 x (0.08 - 0.34)]
0.34 + [ 0.87 x (-0.26)]
0.34 + [-0.226]
0.34 + [1.31 x (0.08 - 0.34)]
0.34 + [1.31 x (-0.26)]
0.34 + [-0.341]
Given the information provided by these two companies, Identify which company has the greater risk and the greater return. Is the risk consistent with the return for each company? By looking at each company's operations and their type of industry comment if the level of risk is justified for each company.© BrainMass Inc. brainmass.com December 24, 2021, 8:12 pm ad1c9bdddf
SOLUTION This solution is FREE courtesy of BrainMass!
The company with the higher beta has the greater risk. This is because beta measures market risk, which is the risk that cannot be diversified. Therefore, Disney is riskier with beta value of 1.31 than Home Depot whose beta value is 0.87.
With regards to the Capital Asset Pricing Model (CAPM), the Kj in the calculation above is the required rate of return. Thus, Home Depot has greater required rate of return than Disney. This is interesting because higher risks usually go together with higher return. However, in this case it is the opposite. Though Disney is more risky than Home Depot, Disney still has lower return than Home Depot. In this particular case, it can attract more investors to Home Depot than to Disney, since investors are mostly risk averse. That is, investors like less risk, more return.
Considering each company's operations and their type of industry, Disney seems however to be less risky and has greater return than Home Depot. Let's look at each company's return on equity (ROE), which is one of the preferred ratios for investors.
Disney (2008): Return on Equity (ROE) Ratio = net income / common equity = $4,427 / $32,323 = 13.70%
Home Depot (2008): net income / total assets = $4,395 / $17,714 = 24.81%
From comparison of the ROE ratio, Home Depot seems to be more attractive to investors than Disney.
However, looking at Home Depot's income statement, it has shown a decrease in sales in the past few years, whereas Disney's sales increase. Therefore, it appears from both company's operations that it does not justify the level of risk for each company. Sales decrease for Home Depot and thus increasing risk for Home Depot. Sales increase for Disney, justifying less risk for Disney. In addition, the ROE ratio for Home Depot is greater than Disney. Again, Home Depot's less risky level is shown by its greater ROE ratio. Disney's lower ROE ratio is also justified by its higher beta value, that is, more risky.
Since Disney is in the entertainment industry, people are now spending less time on vacation because of the recession; therefore, it makes sense that Disney can be more risky. In contrast, people nowadays like to live big, and thus spend on upgrading their homes and all appliances. Thus, putting Home Depot in a less risky position.
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