Reference no: EM132535307

Kings plc is an all-equity financed listed company. It develops customized software for clients which are mainly large civil engineering companies. Nearly all its shares are held by financial institutions. Kings plc's chairman has been dissatisfied with the company's performance for some time. Some directors were also concerned about the way in which the company is perceived by financial markets. In response, the company recently appointed a new Finance Director who advocated using the capital asset pricing model as a means of evaluating risk and interpreting the stock market's reaction to the company. The following initial information was put forward by the Finance Director for two rival companies operating in the same industry:

Company Beta Star plc 0.7 Queen plc 1.4

The Finance Director suggests that the betas of the two companies are used by the stock market to calculate their required rates of return. He also notes, however, that the riskfree rate is 5% each year and the expected return on the market portfolio is 15% each year. The chairman set out his concerns at a meeting of the Board of Directors: 'I fail to understand these calculations. Star plc operates largely in overseas markets with all the risk which that involves, yet you seem to be arguing that it is a lower risk company than Queen plc, whose income is mainly derived from long-term contracts in our domestic UK building industry. I am very concerned that we can take too much notice of the stock market. Take last year for instance, we had to announce a loss and the share price went up.'

Required:

Calculate, using the capital asset pricing model, the required rate of return on equity of:

(i) Star plc

(ii) Queenplc.