Reference no: EM132535328

IML 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.

IML Plc 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 markets reaction to the company.

The following initial information was put forward by the finance director for two rival companies operating in the same industry.

BETA

AZT PLC 0.7

BOR PLC 1.4

The finance director notes that the risk-free rate is 5% each year and the expected rate of return on the market portfolio is 15% each year.
The Chairman set out his concerns at a meeting of the board of director. "I fail to understand these calculations. AZT Plc operates largely oversees markets with all the risk which that involves, yet seem to be arguing that it is a lower risk company than BOR Plc whose income is mainly derived from long-term contracts in our domestic 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:

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

(i) AZT PLC

(ii) BOR PLC

What is the solution of this question