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ASSIGNMENT 4
COST OF CAPITAL AND CAPM MODEL
Q1.
Allison Engines Corporation has established a target capital structure of 40 percent debt
and 60 percent common equity. The firm expects to earn $600 in after-tax income during the
coming year, and it will retain 40 percent of those earnings. The current market price of the firm's
stock is P0 = $28; its last dividend was D0 = $2.20, and its expected growth rate is 6 percent. Allison
can issue new common stock at a 15 percent flotation cost. What will Allison's marginal cost of
equity capital (not the weighted cost of capital) be if it must fund a capital budget requiring $600 in
total new capital?
Q2.
Jessica wishes to know the expected return on her portfolio, when the risk-free rate is 7 per
cent and the return on the market is expected to be 20 per cent. Her portfolio is made up as follows:
Security
Percentage of portfolio
Beta factor of security
R plc
S plc
T plc
U plc
V plc
W plc
15
10
5
30
25
15
0.2
1.2
1.8
0.9
0.2
0.8
Q3.
Company A and Company B both pay an annual dividend of 34.04p per share and this is
expected to carry on indefinitely. The risk-free rate is 8 per cent and the average market rate is 12 per
cent. Company A’s beta is 1.8 and Company B’s beta is 0.8. Calculate the expected return for each
company to predict the market price of each company’s shares.