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
You are given the ordinary shares of company ABC with a market value of $1.50 at the 2015 financial year end. The following are extracts from the companys published accounts at the 2015 financial year end.
Balance sheet at 31 December 2015
| ($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 companys banks base rate
the company incurs a credit risk premium of 1.5% over its banks 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.
Question 1.1:Calculate the risk-free rate.
Question 1.2: Estimate the companys expected return on equity using the capital asset pricing model (CAPM).
Question 1.3: Using the dividend valuation model (DVM) (Gordon growth variation), estimate the expected return on equity.(10 Marks) [use the geometric mean formula to calculate growth]
Question 1.4:Estimate the weighted average cost of capital (WACC) at 31 December 2015, using the average of the two returns on equity calculated in Q1.2 and 1.3 above.
Question 1.5: 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 1.2 and Part 1.3 to illustrate your discussion points.
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