Analysis of Beta
The company that is selected for analysis is Harley-Davidson, Inc. The beta of the company is 0.86 (Yahoo Finance, 2017). Beta is a measure of risk and it gives information on how the returns of the asset/security are likely to respond when there are swings in the market. In this case, the value of the beta is less than 1 and it implies that the stock of the company is 14% less volatile than the market. This shows that the stock of the company will be less sensitive to swings as compared to how the market indices will respond to the same swings. The inclusion of the stock in a portfolio will offer a possibility of low return. It will also pose less risk to the portfolio. This can be explained by the fact that riskier assets attract higher returns than less risky assets (Value-Based Management, 2016).
Capital Asset Pricing Model (CAPM)
Cost of equity = risk free rate + beta * (expected return on the market – risk free rate)
= 4.5% + 0.86 * (6.5%)
= 10.09%
The cost of equity for Harley-Davidson, Inc. is 10.09%.
Cost of Equity
From a theoretical point of view, the cost of equity represents the return that an entity compensates shareholders for the risk of investing in the company. It shows what the market expects the company to pay for investing in the company. Based on the CAPM formula above, the cost of equity highly depends on beta (risk). Thus, a riskier company is expected to pay higher returns than a less risky company.
Beta for a Portfolio
The stock of three companies will be used to create a portfolio. The three companies are Harley-Davidson, Inc., Advanced Emissions Solutions, Inc., and Accenture plc. The beta values for Advanced Emissions Solutions, Inc., and Accenture plc are 2.82 and 1.10 respectively (Yahoo Finance, 2017). The calculation of the beta of the portfolio is represented below.
= (0.86 * 1/3) + (2.82 * 1/3) + (1.10 * 1/3)
= 1.59
The beta of the portfolio is 1.59.
Expected Return of the Portfolio
To calculate the expected return of the portfolio, it is important to first calculate the expected return (cost of equity) for each stock using the CAPM model. The weights and expected return for each stock will be used to compute the expected return of the portfolio. The calculations are summarized below.
The expected return for Advanced Emissions Solutions, Inc.
= 4.5% + 2.82 * (6.5%)
= 22.83%
The expected return for Accenture plc
= 4.5% + 1.10 * (6.5%)
= 11.65%
The expected return of the portfolio
= (10.09% * 1/3) + (22.83% * 1/3) + (11.65% * 1/3)
= 14.85%
The resulting value of the expected return of the portfolio is 14.85%, while the value of beta is 1.59. The portfolio that is made up of the three stocks does not sufficiently diversify the risk away. It can be observed that the portfolio will be 59% more volatile than the market. The volatility of the portfolio is quite high and an investor can reduce the risk level by adding more assets into the portfolio or eliminating assets that have a high beta. Alternatively, the investor can also change the weights of the assets in the portfolio. However, this decision will depend on the risk appetite of the investor (Value-Based Management, 2016).
References
Value Based Management. (2016). Summary of the capital asset pricing model. Web.
Yahoo Finance. (2017). Harley-Davidson, Inc. Web.