QUESTION EIGHT

IML Plc is an all equity financed listed company. It develops customized software for clients which are mainly large civil engineering companies. Nearly all its shares are held by financial institutions.

IML Plc chairman has been dissatisfied with the company's performance for some time. Some directors were also concerned about the way in which the company is perceived by financial markets. In response, the company recently appointed a new finance director who advocated using the capital asset pricing model as a means of evaluating risk and interpreting the stock markets reaction to the company.

The following initial information was put forward by the finance director for two rival companies operating in the same industry.

BETA

AZT PLC0.7

BOR PLC1.4

The finance director notes that the risk-free rate is 5% each year and the expected rate of return on the market portfolio is 15% each year.

The Chairman set out his concerns at a meeting of the board of director. "I fail to understand these calculations. AZT Plc operates largely oversees markets with all the risk which that involves, yet seem to be arguing that it is a lower risk company than BOR Plc whose income is mainly derived from long-term contracts in our domestic building industry. I am very concerned that we can take too much notice of the stock market. Take last year for instance, we had to announce a loss and the share price went up."

Required:

a)Calculate, using the capital asset pricing model, the required rate of return on equity of:

(i)AZT PLC(6 marks)

(ii)BOR PLC

b)Calculate the beta of IML Plc, assuming its required annual rate of return on equity is 7% and the stock market uses the capital asset pricing model to calculate the beta, and explain the significance of the beta factor.(6 marks)

c)As the new finance director,provide a memorandum to the Chairman which explains, in language understandable to a non-financial manager, the following:

(i)The assumptions and limitations of the capital asset pricing model; and

(ii)An explanation of why IMP PLC's share price could rise following the announcements of a loss.

In doing so, discuss the observations and concerns expressed by the chairman. You may refer where appropriate to you in (a) and (b) above.