Suppose XYZ is a small value stock and that you use both the CAPM and the Fama-French model to compute its cost of capital. Under which model is the cost of capital for xyz likely to be higher?
What will be an ideal response?
Answer: It is likely to be higher under the Fama-French model. The reason is that the Fama-French model has two additional factors in addition to the return on the value-weighted market portfolio in excess of the risk-free return, as in the CAPM. These factors are the difference in the return on a portfolio of small firms and the return on a portfolio of big firms (small minus big [SMB]) and the difference between the return on a portfolio of firms with high values of book equity to market equity (BE/ME) and the return on a portfolio of firms with low values of BE/ME (high minus low [HML]). These two factors carry positive risk premiums. As a small value stock, XYZ stock will have positive exposures to these two factors and therefore likely have a higher cost of capital, than if only the CAPM were used.
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