The market is currently yielding a return of 16% while Treasury bills are yielding 10%. Shares of Lime Spider Ltd have a covariance of 7.5 with the market while the market has a variance of 4.5.
Required:
Determine the required rate of return for Lime Spider Ltd’s shares. (3 marks)
The required rate of return on Lime Spider’s shares is therefore 20 per cent.
The directors of Sunland Company, a company which has 75% of its operations in the retail sector and 25% in manufacturing, are trying to derive the firm’s cost of equity. However, since the company is not listed, it has been difficult to determine an appropriate beta factor. The following information was researched:
Required:
Calculate the cost of equity of Sunland Company using the Capital Asset Pricing Model. (8 marks)
In order to use CAPM we shall need to derive a suitable equity beta for Sunland Co. This will be done by first finding a suitable asset beta (based on the asset betas of the 2 parts of the business) and gearing up to reflect Sunland Co’s 50:50 gearing level. Retail industry: the asset beta of retail operations can be found from the industry information as follows: (assuming the debt beta is zero)
Manufacturing industry: Similarly, the asset beta for manufacturing operations is:
Sunland Co asset beta: Hence, the asset beta of Sunland will be a weighted average of these two asset betas: ß a (Sunland) = (0.75 × 1.02) + (0.25 × 0.92) = 1.00.
Sunland Co equity beta: So, regearing this asset beta now gives: 1.00 = ße × [50/(50 + 50(1 – 0.30))] So, ße = 1.00/0.59 = 1.69
Sunland Co cost of equity, using CAPM: Ke = RF + ß (E(RM) – RF) = 3% + (1.69 × 6%) = 13.1%
