Question 3

John plc has 10 million shares outstanding and the current share price is 4. These ordinary shares have a beta of 1.5. The risk-free rate on government bonds is 5% per year and the expected rate of return on the market portfolio is 15% per year.

i) Use the CAPM model to calculate the firms cost of equity (5 marks)

ii) Assuming the corporation tax rate is 30%, what is the weighted average of cost of capital (WACC) if the market value of its debt is 10m with costs of 10% per year before allowing for tax shield benefits? (10 marks)

iii) What is the drawback of using CAPM to estimate cost of capital? (5 marks)