Question

Please answer all question with working and calculation. Tq

Question Two Forrester Ltd. is a listed company that owns and operates a large number of wholesale outlets in its home country. The following is an extract from the Statement of Financial Position of the company at 30 September 2015: Sm 200 200 Ordinary shares of si each Reserves 9% irredeemable 51 preference shares 8% loan notes 2016 250 The ordinary shares were quoted at $3 per share ex div on 30 September 2015. The beta value of the Company's equity shares is 0.8, the annual yield on treasury bills is 5%, and financial markets expect an average annual return of 15%. The market price of preference shares was 50.90 ex div on 30 September 2015 Loan notes interest is paid annually in arrears and is allowable for tax at a rate of 30%. The loan notes were priced at $100.57 ex interest per $100 nominal on 30 September 2015. Loan notes are redeemable on 30 September 2016 at par. Assume that taxation is payable at the end of the year in which taxable profits arise. Required: (a) Using the capital asset pricing model, calculate the required rate of return on equity of Forrester Ltd. at 30 September 2015 (3 marks) (b) Briefly explain how the beta value is calculated and the meaning of the value (4 marks) (c) Calculate the weighted average cost of capital of Forrester Ltd. at 30 September 2015, using your calculation in answer to requirement (a) above for the cost of equity. (10 marks) (d) Explain the limitations of the capital asset pricing model as a tool to calculate the cost of equity. (8 marks) (Total-25 marks)

Answer 1

1	Require rate of return of equity by using CAPM model of forrestar LTD. At 30 September 2015
	Require rate of return of equity =
formula	ERi​=Rf​+βi​(ERm​−Rf​)
value	5%+(15%-5%).80		=	13%
	Notes
	ERi​=expected return of investment =13%
	Rf​=risk-free rate= 5%
	B= Beta of the investment=.80
	ERm​−Rf= market risk premium (15%-5%)

2. How to beta value calculate  and meaning of value

A stock that swings more than the market over time has a beta greater than 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks tend to be riskier but provide the potential for higher returns; low-beta stocks pose less risk but typically yield lower returns.

As a result, beta is often used as a risk-reward measure meaning it helps investors determine how much risk their willing to take to achieve the return for taking on that risk. A stock's price variability is important to consider when assessing risk. If you think of risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.

How to Calculate Beta

To calculate the beta of a security, the covariance between the return of the security and the return of the market must be known, as well as the variance of the market returns.

​Beta= Variance/Covariance​

Covariance=Measure of a stock’s return relative to that of market

Variance= Mearsure of how the market Move Relatives to it's mean

3. Weight avarge cost of capital

The Formula for WACC

​WACC=(E/V​×Re)+(D/V​×Rd×(1−Tc))

where:E=Market value of the firm’s equity

D=Market value of the firm’s debt

V=E+D

Re=Cost of equity

Rd=Cost of debt

Tc=Corporate tax rate​

After applying the above formula

E( Market value of equity) = 200*3=600

D(Market value of Debt)= 250/100*100.53 = 251.425

E( Market value of prefernce share)= 50/1*0.90=45

E+D( total value) = 600+251.425+45 = 896.425

require rate of retun= 13%(as per answer 1)

rate of debt after tax* = .08-30%of .08=5.60%

WACC = 0.13*600/896.425+9%*45/896.4+5.60%*251.425/896.425 = 0.1351 or 13.51%

4. Limitation of capital asset pricing model as a tool to calculate cost of equity

DISADVANTAGES OF CAPM

I) TOO MANY ASSUMPTIONS

The CAPM model is based on too many assumptions, which many criticize as being unrealistic. Therefore, it may not provide the correct results.

II) ASSIGNING VALUES TO CAPM VARIABLES

Risk-free Rate (Rf): The commonly accepted rate used as the Rf is the yield on short--term government securities. The problem with using this input is that the yield changes daily, creating volatility.

Return on the market (Rm): The return on a stock market is the sum of the average capital gain and the average dividend yield. The market return can be negative in a short-term market. As the result, the long-term market return is utilized. The other major drawback is that these returns are backward looking & not futuristic

Beta (B): Beta values are regularly published on all stock exchanges regularly for all listed companies. The issue here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time

III) ABILITY TO BORROW AT RISK-FREE RATE

There are four major assumptions of CAPM. One of the assumptions is that investor can borrow & lend the funds at the risk-free rate. This assumption is unrealistic for the real world. The individual investors are unable to borrow or lend at the same return as the US government.

Therefore expected return calculated by CAPM model may not be correct in this situation.

IV) DETERMINATION OF PROJECT PROXY BETA

The problem may arise in using the CAPM to calculate a project-specific discount rate. Generally, equity beta & portfolio/investment beta are different. Therefore, the company needs to find a proxy beta for the project.

However, finding accurate proxy beta might be difficult and can affect the reliability of outcome.