Question 1

The following information relates to Tyro Ltd, a manufacturing company (all figures in $000):

Financial information for years ending 31 December

The current market value of the shares is $1.13 while the debentures are quoted at $62.50 per $100. Tyro's equity beta has been calculated as 1.2 and the current risk-free rate is 12%. The rate of corporation tax throughout the period has been 50% and the basic rate of income tax 30%. Tyro has consulted you on the cost of capital to be used in appraising a major project in the same risk class as its existing business.

Required

(a) Calculate the weighted-average cost of capital of Tyro Ltd.

(b) Calculate the required return on equity using the capital asset pricing model. You can assume that the market risk premium is equal to 9%.

(c) Calculate an asset beta relevant to the project and use this to compute a project cost of capital.

(d) Compare the results obtained and comment briefly on the different models used. (You should state clearly any additional assumptions you make).

Question 2

The management of Nelson PLC wish to estimate their firm's equity beta. Nelson has had a stock market quotation for only two months and the financial manager feels that it would be inappropriate to attempt to estimate beta from the actual share price behaviour of such a short period. Instead it is proposed to ascertain, and where necessary adjust, the observed equity betas of other companies operating in the same industry and with the same operating characteristics as Nelson as these should be based on similar levels of systematic risk and be capable of providing an accurate estimate of Nelson's Three companies have been identified as firms having operations in the same industry as Nelson which utilize identical operating characteristics. However, only one company, Oak PLC, operates exclusively in the same industry as Nelson. The other two companies have some dissimilar activities or opportunities in addition to operating characteristics which are identical with those of Nelson.

Details of the three companies are as follows:

- Oak PLC: observed equity beta, 1.12; capital structure at market values is 60% equity, 40% debt.

- Beech PLC: observed equity beta, 1.11. It is estimated that 30% of the current market value of Beech is caused by risky growth opportunities which have an estimated beta of 1.9. The growth opportunities are reflected in the observed beta. The current operating activities of Beech are identical with those of Nelson. Beech is financed entirely by equity.

- Pine PLC: observed equity beta, 1.14. Pine has two divisions - East and West. East's operating characteristics are considered to be identical with those of Nelson. The operating characteristics of West are considered to be 50% more risky than those of East. In terms of financial valuation East is estimated as being twice as valuable as West. Nelson is financed entirely by equity. The tax rate is 40%. 25% debt. 75% equity.

Required

(a) Assuming all debt is virtually risk free; determine three estimates of the likely equity beta of Nelson PLC. The three estimates should be based separately on the information provided for Oak PLC, Beech PLC and Pine PLC.

(b) Explain why the estimated beta of Nelson, when eventually determined from observed share price movements, may differ from those derived from the approach employed in (a).

(c) Specify the reasons why a company which has a high level of share price volatility and is generally considered to be extremely risky can have a lower beta value, and therefore lower financial risk, than an equally geared firm whose share price is much less volatile.

(d) Compare the results obtained and comment briefly on the different models used. (You should state clearly any additional assumptions you make).