You are given the ordinary shares of company ABC with a market value of $1.50 at

Question

You are given the ordinary shares of company ABC with a market value of $1.50 at the 2015 financial year end. The following are extracts from the company’s published accounts at the 2015 financial year end.

Balance sheet at 31 December 2015

($m)

Capital and reserves

Share capital

512

Revaluation reserve

294

Retained earnings

1,306

Net borrowings

1,920

Income statement for the year ended 31 December 2015

($m)

Operating profit

952

Finance expenses

144

Profit before taxation

808

Income tax expense

202

Profit for the period

606

A summary of total dividends paid is shown below.

Year

2012

2013

2014

2015

Dividend per share (in Cents)

5.75

6.10

6.47

6.86

Note the following:

issued share capital consists only of ordinary 10 cents shares

the equity beta for the company is 1.125

the equity risk premium is 4%

borrowings were unchanged during 2015 and were all linked to the company’s bank’s base rate

the company incurs a credit risk premium of 1.5% over its bank’s base lending rate (also known as prime rate or minimum lending rate), which has not changed over the year

at the present time, bank base rates are 1% higher than the yield on short-term US Treasury debt.

Note : Consider Risk-Free Rate (Rf) = 5%

Question 1.1: Estimate the company’s expected return on equity using the capital asset pricing model (CAPM).

Question 1.2: Using the dividend valuation model (DVM) (Gordon growth variation), estimate the expected return on equity. [use the geometric mean formula to calculate growth]

Question 1.3: Estimate the weighted average cost of capital (WACC) at 31 December 2015, using the average of the two returns on equity calculated in Q1.1 and 1.2 above.

                       

Question 1.4: Comment on the relative advantages and disadvantages of the CAPM and the DVM (Gordon growth variation) as a basis for estimating the expected return on equity of a firm. Suggest reasons why they might give different estimates. Use your results from Part 1.1 and Part 1.2 to illustrate your discussion points. [200 to 400 words]

($m)

Capital and reserves

Share capital

512

Revaluation reserve

294

Retained earnings

1,306

Net borrowings

1,920

Explanation / Answer

Ans. 1.1 Calculation of KE (using CAPM module) = Rf+(Risk premium) beta

=5+(4%)X1.125= 9.50%

1.2 Calculation of KE (using Gorden Growth module)

Calculation of Growth = (5.75-6.10)/5.75X100 = 6% or (6.47-6.86)/6.47X100 = 6%

Growth is 6%

Dividend latest = 6.86 cents or $.0686

Market value = $1.50

Ke = .0686 X100+6% = 10.57%

1.50

1.3 Calculation of WACC

calcualtion of cost of debt or Kd= 5+1+1.5 = 7.50 (1-.25) = 5.625%

*Tax rate = 202/808X100 = 25%

WACC calculation by using CAPM model for Ke

Weight of equity and Debt.   

Weight

Equity = $1818 (512+1306) .49

Debt =$1920 .51

Total =$3738 1

WACC = 9.50X.49+ 5.625X.51 = 4.655+2.869= 7.524%

Calculation of WACC by using Gorden module

WACC= 10.57X.49+5.625X.51= 5.18+2.869 = 8.05%

1.4 Advantage and disadvantage of CAPM and DVM

CAPM

Advantage

-Market Return: Under CAPM module we are using market risk premium and Risk free rate for that return is subject to market return.

-Beta: Company Return will effect through the beta factory.

Disadvantage:

Market Return: Company Return always depended on market rate of return, higher beta means higher return and higher loss as per market return.

Advantage and disadvantage of DVM

-Growth: Company return is depend on Growth of company as per historical data, that means company is shown correct return as per historical data.

Disadvantage:

-it is calculated with the using of dividend, if company is dividend is not declared countine 3-4yrs we are unable to calculate Ke.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.