ACCA FM Syllabus E. Business Finance - capm - Past Papers ^{5 / 7}

The 8% loan notes are convertible into eight ordinary shares per loan note in seven years’ time. If not converted, the loan notes can be redeemed on the same future date at their nominal value of $100. Par Co has a cost of debt of 9% per year.

The ordinary shares of Par Co have a nominal value of $1 per share. The current ex dividend share price of the company is $10·90 per share and share prices are expected to grow by 6% per year for the foreseeable future. The equity beta of Par Co is 1·2.

The loan notes are secured on non-current assets of Par Co and the bank loan is secured by a floating charge on the current assets of the company.

Which of the following statements relating to the capital asset pricing model is correct?

A. The equity beta of Par Co considers only business risk
B. The capital asset pricing model considers systematic risk and unsystematic risk
C. The equity beta of Par Co indicates that the company is more risky than the market as a whole
D. The debt beta of Par Co is zero

The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7·50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107·14.

Fence Co plans to invest in a project which is different to its existing business operations and has identified a company in the same business area as the project, Hex Co. The equity beta of Hex Co is 1·2 and the company has an equity market value of $54 million. The market value of the debt of Hex Co is $12 million.

The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation tax at a rate of 20% per year.

Required:
(b) Calculate a cost of equity which could be used in appraising the new project. (4 marks)

Card Co has in issue 8 million shares with an ex dividend market value of $7·16 per share. A dividend of 62 cents per share for 2013 has just been paid. The pattern of recent dividends is as follows:

Card Co also has in issue 8•5% bonds redeemable in five years’ time with a total nominal value of $5 million. The market value of each $100 bond is $103•42. Redemption will be at nominal value.
Card Co is planning to invest a significant amount of money into a joint venture in a new business area. It has identified a proxy company with a similar business risk to the joint venture. The proxy company has an equity beta of 1•038 and is financed 75% by equity and 25% by debt, on a market value basis.

The current risk-free rate of return is 4% and the average equity risk premium is 5%. Card Co pays profit tax at a rate of 30% per year and has an equity beta of 1•6.

Required:

Calculate a project-specific cost of equity for Card Co for the planned joint venture. (4 marks)

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)