MN12004: Fundamentals of Finance

Seminar Question Set 7: WACC and CAPM/Portfolio Theory

1. Unida Systems has 40 million shares outstanding trading for $10 per share. In addition,
Unida has $100 million in outstanding debt. Suppose Unida’s equity cost of capital is 15%, its
debt cost of capital is 8%, and the corporate tax rate is 40%.
a. What is Unida’s after-tax debt cost of capital?
b. What is Unida’s weighted average cost of capital?

a. kd = 8%  (1 – 40%) = 4.8%
b. Rwacc = (400/500  15%) + (100/500  4.8%) = 12.96%

2. Bristol plc is financed by a mixture of 450,000 ordinary shares, 300,000 £1 nominal value
4.5% irredeemable preference shares and 20,000 £100 nominal value 3% redeemable
debentures. The market value of ordinary share is £3.2 per share. The preference shares are
currently valued at 85p per share and current interest market price of debenture is £80 with
a premium of 5% on redemption of the debt in 5 years’ time. The market return of London
stock exchange all share index is 8.4%, 5 years government bond is 4% and the company’s
beta is 1.2. The corporate tax rate faced by Bristol plc is 35%. Calculate the cost of each of
the components of capital and the firm’s WACC.

Cost of equity
k e=r f + β ( r m −r f )=0.04 +1.2 ( 0.084−0.04 ) =0.0928

Cost of preference share

D 0.045
k p= = =0.0529
S 0 0.85

Cost of debt
3∗(1−0.35) 1.95 105
80= + +… ..+
(1+k d (1−T )) (1+ k d ( 1−T ) )2 ¿¿¿
Time Cash flow PVF@5% PV@5% PVF@10% PV@10%
0 -80 1 -80 1 -80
1-5 1.95 4.329 8.44 3.791 7.39
5 105 0.784 82.32 0.621 65.2
Total 10.76 -7.41
10.76
k d ( 1−T )=5 %+ ( 10 %−5 % ) =7.924 %=0.0796 (This is after-tax cost of debt)
( 10.76+7.41 )

Market value
Equity 0.0928 450000*3.2 = 1440000
Preference share 0.0529 300000*0.85=255000
Debt(1-T) 0.0796 20000*80=1600000
 1440000∗0.0928+255000∗0.0529+1600000∗0.0796
WACC = =0.0833
1440000+255000+1600000

3. Mr Picardo has an equity portfolio consisting of 10 listed companies. He is now considering

adding a further share, which would represent 10% of the new portfolio if he decides to invest
in it. He has shortlisted two shares and has made some predictions about returns and
standard deviations, as follows:

Predicted return % Standard deviation %

Share A 20 20
Share B 22 18
Market 15 10
Current Portfolio 16 17

Mr Picardo’s friend, who knows that he is risk averse, had a quick look at the information
and without doing any further calculations, recommended he invest in Share B.

a) Explain why you think his friend made that recommendation and whether you think it is a
valid reason.

Mr Picardo does some further research and finds some correlation coefficients, as follows:

Market returns Current portfolio returns

Share A returns 0.4 0.7
Share B returns 0.9 0.2

The risk free rate of interest is 2%

b) Mr Picardo’s wife says he could use portfolio theory to help decide which share he should
add to his current holdings. If he used portfolio theory, what conclusion would he come to?

c) Mr Picardo’s mother believes he should use CAPM to analyse this decision. If he did this,
which share would be preferable?

d) Compare the advice in a, b, and c and explain any differences. Whose advice should he
listen to?

(a) If Mr Picardo is risk averse he must require a higher expected return to take on more risk
(which we generally measure using standard deviation or variance of returns). Share B has higher
expected return and lower std dev of returns than A, so seems better on both measures.

(b) Assuming Mr P’s predictions are correct we can consider the expected return and std dev of the
new portfolio, and see if A or B gives a better result.

With A:

, giving a std dev of 0.1676.

Similar calculations with B give and .

So combining current portfolio with A gives slightly lower expected return and a higher standard
deviation, so again B is preferred.

c)

First calculate betas:

σ im
β== 2 Definition of Beta
σm

We don’t know σ im

σ im
But we can use ρi,m = Definition of correlation
σiσm

σ im = ρi,m x σ i σ m

ρ i,m x σ i σ m ρ i,m x σ i
β= 2 = Now we know everything and….
σm σm

So and .

We can now compare the fair returns according to CAPM with the predicted ones:

A is predicted to return 7.6% higher than required for its systematic risk, while B is predicted to
return 1.06% less. We should therefore recommend Share A.

d) Mr P’s friend picked the share that would be chosen under portfolio theory conditions, but used
the wrong decision criterion, because they ignored Mr P’s current portfolio. All they did was
compare individual expected returns and risk of the two shares.

Mr P’s wife recognised that Mr P’s current portfolio returns are correlated with those of the two
assets, so the ultimate standard deviation of the portfolio will be determined by the standard
deviation of the component parts adjusted for this correlation. In fact, A’s returns are highly
correlated with those of the portfolio, so there is less diversification benefit when investing in A than
in B. The conclusion is that B’s effect on portfolio risk is better than A’s.

Mr P’s mother used CAPM. This result is appropriate when investors hold the market portfolio - or a
mini-version of it - as their risky asset. B’s returns are very highly correlated with those of the market
and it has a high beta, which determines the return required to compensate for risk. A’s lower
correlation means that a rational investor could - and should - diversify away much of A’s risk, so
that a lower return is acceptable.

Who is right depends on what Mr P’s current portfolio looks like – is it already well diversified?