At the market value, Carlton (UK) Ltd. has a capital structure with the equity to value ratio being 40% and the debt to value ratio being 60 %. The before-tax cost of the debt is 6 %. Carltons shares on the London stock market have a beta of 1.10. The UK risk-free rate is 3% and the market risk premium is 5%. The corporate tax rate in the UK is 33 %.

With this information,

1. Calculate the required return on Carltons equity.

2. Find Carltons weighted average cost of capital (WACC).

c. Carlton (UK) Ltd. can also raise capital in the American market. The companys debt to value ratio then would become 25% and its equity to value ratio would become 75%. Its pre-tax cost of debt becomes 5.5 %. The beta of Carltons shares is 1.3 against the Dow Jones Industrial Average and Carltons risk premium over the USA risk-free rate is 6 %. Interest is deductible in the USA at the corporate tax rate of 30 %. Find out Carltons cost of equity and its after-tax cost of debt. What is Carltons weighted average cost of capital in the USA market? Critically comment on the difference between Carltons cost of capital in the UK and USA markets.

d. The standard deviation of the return to an asset on the London stock market is 15 %. The standard deviation of an asset in an emerging market is 22 %. An investor plans to form a portfolio using the two assets in equal weights. Calculate standard deviation of the return to this equally weighted portfolio in the following four situations:

(i) perfectly positive correlation,

(ii) perfectly negative correlation,

(iii) zero correlation, and

(iv) a correlation of 0.37.

Critically comment on the effective ways of portfolio construction with reference to the above example.