Question 1.

a Perry Motors

D1
i. Value of common stock: P0 =
rs
D0 = D1 for zero growth model
1.80
P0 =
0.12
P0 = $15.00

The value of common stock under a zero growth model is $15.00

D 0(1+ g)
ii. Value of equity/ common stock: Ve =
k e−g
Ke = cost of equity
Growth rate = g
D0 = current dividend
1.80(1+0.05)
Ve =
0.12−0.05
1.89
Ve =
0.07
Ve = $27.00

The value of equity under the constant growth model is $27.00

iii. Calculation of dividends

D1 = 1.80(1+0.05)1
D1 = 1.89

D2 = 1.80(1+0.05)2
D2 = 1.9845

D3 = 1.80(1+0.05)3
D3 = 2.083725

D4 = 1.80(1+0.05)3× (1+0.04)
D4 = 2.167074
 Present Value of the perpetual dividend
2.167074
Present value to year 3 =
0.12−0.04
Present Value = $27.088425

Year Cash flow Present Value Present Value

Interest Factor
1 1.89 0.892857142 1.6875
2 1.9845 0.797193877 1.58203125
3 2.083725 0.711780247 1.483154297
3 27.088425 0.711780247 19.28100586
Present Value 24.03369141

The value of equity on the multiple growth model is $24.03

Question b.

The Capital Asset Pricing Model (CAPM) is a theory that explains how financial assets are
priced. It is based on the notion that portfolio return and risk are the only elements considered
in developing the model. The CAPM specifies that the return on any asset is a function of the
return on a risk free asset plus a risk premium.

The security market line is a line drawn on a chart and serves as a graphical representation of
the capital asset pricing model. It shows the relationship between the expected return of each
asset and its beta. Assets that plot on the security market line are correctly priced or are in
equilibrium, whilst those that plot above the security market line are under-priced and those
that plot below the security market line are over-priced.

Factors that cause a shift in the security market line include inflation or deflation, economic
and political changes, or other macroeconomic factors such as unemployment, exchange rate
fluctuations, and changes in the levels of interest rates among other economic and financial
factors.
 Question 2

COV (R A ; RM )
i. Beta of Aftek Limited
Variance( Market )

Expected Return of Aftek Limited

E (RA) = 0.18 ×0.15+ 0.24 ×0.25+ 0.26 ×0.38+.32 ×0.46
E (RA) = 0.027+ 0.06+0.0988+0.1472
E (RA) = 0.333

Expected return of Paraan Limited

E (Rp) = 0.18 ×0.09+ 0.24 ×0.14 +0.26 ×0.27 +0.32× 0.33

E (Rp) = 0.0162+0.0336+ 0.0702+ 0.1056

E (Rp) = 0.2256

Expected Market Return

E (Rm) = 0.18 ×0.07 +0.24 × 0.11+ 0.26 ×0.18+0.32 ×0.25

E (Rm) = 0.0126+ 0.0264+0.0468+0.08

E (Rm) = 0.1658

Covariance of returns between Aftek and the market

Cov (RA, RM) =

0.18 ( 0.15−0.333 ) ( 0.07−0.1658 )+ 0.24 ( 0.25−0.333 )( 0.11−0.1658 ) +0.26 ( 0.38−0.333 ) ( 0.18−0.1658 )+ 0.32(

Cov (RA, RM) = 0.0078626

Covariance of returns between Paraan Limited and the market

Cov (Rp, RM) =

0.18 ( 0.09−0.2256 ) ( 0.07−0.1658 )+ 0.24 ( 0.14−0.2256 )( 0.11−0.1658 ) +0.26 ( 027−0.2256 ) ( 0.18−0.1658 )+ 0.
Cov (Rp, RM) = 0.00646152

Variance of the market

Var (M) = 0.18 ( 0.07−0.1658 ) ¿2 +0.24 ( 0.11−0.1658 ) ¿ 2+ 0.26 ( 0.18−0.1658 ) ¿2 +0.32 ¿

Var (M) = 0.00472036

COV ( R A ; RM )
Beta of Aftek Limited: βA =
Variance( Market )

0.0078626
=
0.00472036

= 1.665678042….

= 1.67

COV (R P ; RM )
Beta of Paraan Limited: βp =
Variance( Market )

0.00646152
=
0.00472036

= 1.368861697

= 1.37

ii. Calculation of the required rate of Return using the Capital Asset Pricing Model
Aftek Limited
RA = rf + β (Rm−Rf )
= 0.065+1.67 (0.1658−0.065)
= 0.233

Aftek stock is under-priced since the expected return is more than the required rate of return.

Paraan Limited

Rp = rf + β ( Rm−Rf )
 = 0.065+1.37 (0.1658−0.065)

= 0.203

Paraan Limited plots above the required rate of return, hence it is under-priced.

iii. Standard deviation of Aftek Limited

Variance = 0.18 ¿
Variance =0.013417
Standard deviation = √ 0.013417
Standard deviation = 0.115831774

Standard deviation of Paraan Limited

Variance = 0.18 ¿
Variance = 0.00906864
Standard deviation = √ 0.00906864
Standard deviation = 0.095229407

Market standard deviation = √ 0.00472036

= 0.06870
Aftek Limited
0.06870
Proportion of systematic risk = ×100 %
0.115831
= 59.3%
Proportion of unsystematic risk = 100% - 59.3%
= 40.7%
Paraan Limited
0.06870
Proportion of systematic risk = ×100 %
0.09523
= 72.1%
Proportion of unsystematic risk = 100% - 72.1%
= 27.9%
iv. Calculating coefficient of variation (CV)
Aftek Limited
Standard deviation
CV = ×100 %
Expected return
 = 0.115831774/0.333 ×100%
= 34.78%

Paraan Limited
0.095229407
CV = ×100 %
0.2256
= 42.21%
The analyst should invest in Aftek Limited since it has a lower risk per unit of
return as indicated by the coefficient of variation.