Problem
Apple wishes to estimate its cost of capital in order to evaluate a new iPhone project. The volatility of Apple stock is 0.45. The covariance of Apple with the market is 0.06. The market risk premium is 7% and the risk-free rate is 2%. The standard deviation of the market is 22%.
I. What is Apple's CAPM Beta? With that beta, what does CAPM say about Apple's expected return? This return is also frequently used as Apple's cost of capital in NPV calculation.
II. Your friend likes Apple stock and wishes to invest all his money in Apple. Offer your friend a better investment strategy on the Capital Market Line that will have the same expected return as Apple's but will have lower volatility. (Calculate the weights (y and 1-y) and the volatility).
III. One concern with the analysis in (I) is that Apple has two lines of business - the first is hardware (iPhone, iPad, etc.), and the second is entertainment services (Apple TV, Apple Music, etc.). These two businesses differ in their risk profile - the hardware line is considered less risky than the entertainment service line. If you use Apple's expected return, calculated in (I), as the cost of capital to evaluate the NPV of the iPhone project, will your NPV be higher than what it should be, lower than what it should be, or correct? Explain (no calculations are required).