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.