Question

A company's current EPS is Ksh 12. The firm pays out 40% of its earnings as dividend and has a growth rate of 6% p.a. which is expected to continue into perpetuity. The company has a beta value of 1.4 and the risk-free rate is 10%. The expected market return is 15%. Required:

(a) Using CAPM, compute the expected return on the company's equity.
(b) What implications does CAPM bring if it is used to determine a firm's cost of equity?

Answer 1

The expected return on the company's equity using CAPM is 17%. CAPM provides a theoretical framework linking risk and return, but it assumes a simplified market and should be used carefully along with other analysis methods.

Step-by-step explanation:

To compute the expected return on the company's equity using the Capital Asset Pricing Model (CAPM), we use the formula:

Expected Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)

Given the company's beta value of 1.4, a risk-free rate of 10%, and an expected market return of 15%, we can calculate the expected return as follows:

Expected Return = 10% + 1.4 x (15% - 10%) = 10% + 1.4 x 5% = 10% + 7% = 17%

As for the implications of using CAPM to determine a firm's cost of equity, CAPM considers the relationship between the risk of the equity investment and the expected return. This helps investors to understand the compensation they require for taking on additional risk. However, CAPM assumes a simplified market structure and may not always capture all the dynamic risk factors affecting required returns in the real world. Therefore, while CAPM provides a theoretical framework, it should be used with caution and in conjunction with other methods of analysis.