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Finance Question: Beta and Risk

You are working as an intern at Coral Gables Products, a privately owned manufacturing
company. You got into a discussion with the Chief Financial Officer (CFO) at Coral Gables
about weighted average cost of capital calculations. She pointed out that, just as the beta
of the assets of a firm equals a weighted average of the betas for the individual assets (as
shown below):

Bn Asset Portfolio = SUM_(t - 1, n) xiBi = x1B1 + x2B2 + ... + xnBn

The beta of the assets of a firm also equals a weighted average of the betas for the debt, preferred stock, and common stock of a firm:

Bn Asset Portfolio = SUM_(i = 1, n) xiBi = x_Debt * B_debt + x_ps * B_ps + x_cs * B_cs

a) Why must this be true? Please provide your explanation with appropriate examples.

b) Discuss your understanding of WACC and explain how the individual cost of each capital component (equity, preference and debt capital) can be calculated.

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Solution Preview

a. Betas measure risk relative to market risk. It ranges from 0 to 1. When beta is zero for an asset there is no risk associated with this asset and hence expected return is not high. When beta is one, the risk associated with the asset is highest and hence expected return is high. For an investor goal is to collect a large number of assets and form a portfolio to minimize risk with deterministic rate of return. Hence, for a portfolio, beta is equal to weighted average of betas for the individual assets.

For example a portfolio consists of three stocks with betas 0.8, 0.6, and 0.4. These ...

Solution Summary

Finance questions about beta and risks for Coral Gables Products are examined.