Capital asset pricing model and sources of capital

CAPM

The company I am going to use is Google. According to Yahoo! Finance (2012), the beta for Google is 1.18. This beta means that the company has a greater risk than the market overall (Investopedia, 2012). The market risk is 1.0, so a beta greater than this indicates that the firm's stock is more volatile than the broad market. A beta below 1.0 indicates that the firm's stock is less volatile than the broad market.

The current maturity on one-year Treasuries is 0.18%, according to FRED (2012). If we assume a market risk premium of 6.5%, the cost of equity for Google can be calculated with the capital asset pricing model:

Investopedia (2012)

The estimated rate of return for Google using CAPM is 7.85%.

Two other companies are FedEx and Southwest Airlines. The beta for FedEx is 1.62 and the beta for Southwest is 1.23. If a portfolio is comprised of all three in equal proportions, the beta of the portfolio will be:

(1/3)(1.18) + (1/3)(1.62) + (1/3)(1.23) = 0.393 + 0.54 + 0.41 = 1.343

I do not feel that this three-stock portfolio is significantly diversified. A portfolio that is significantly diversified will have a beta near one, in other words it will track the broad market portfolio closely. In this case, the portfolio is over one-third more volatile than the broad market. All of the securities within the portfolio are fairly volatile. Therefore, the portfolio is not sufficiently diversified. The expected rate of return on this portfolio is:

(0.18) + (1.343)(6.5) = 8.9095%

Part II. For Google, the two projects could be the development of the next generation of Android, and a long-run project could be the building of a campus in a foreign country, perhaps India, to supplement the main headquarters in California. For the current project, the Android development, the most appropriate source of financing is going to be cash and this should be the source of financing for the long-run project as there. There are a few different reasons for this. The first is that Google has the cash, which is not currently invested in a project. The balance sheet shows a cash balance of $10 billion with short-term investments of $34.6 billion. This is money that it not earning much return, so Google would improve its net worth by undertaking any project that is earning more than what short-term investments are paying.