AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co:

The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an ordinary dividend of 36·3 cents per share has just been paid. Historic dividend payments have been as follows:

The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The 7% bonds are redeemable at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104·50 per bond. The bank loan has a variable interest rate that has averaged 4% per year in recent years.

AMH Co pays profit tax at an annual rate of 30% per year.

Required:

Discuss how the capital asset pricing model can be used to calculate a project-specific cost of capital for AMH Co, referring in your discussion to the key concepts of systematic risk, business risk and financial risk.

(8 marks)