FAO: DIRECTORS, NATURALLY FRESH PLC
2. Required Rate of Return on Equity3
4. Capital Asset Pricing Model4
5.1 Limitations of CAPM4
5.2 The APT Model4
5.3 The Three-Factor Model4
5.4 Required Rate of Return using APT or Three-Factor 5 Model
6.5 How bond prices are determined5
6.6 The Rate of Return on the bonds6
6.1Appendix 1 – after tax rate of return on bonds7
6.2 Appendix 2 – Excel Working and screen shot
Naturally Fresh Plc are considering converting a number of their farms in Southern Europe into campsites following difficult trading conditions.
This report will look at the required rate of returns on the equity as well as the bonds, whilst explaining the models used to calculate the returns and also provide a recommendation on whether the investment opportunity should be accepted by Naturally Fresh Plc.
2. Required Rate of Return on Equity
E(R)| Expected/Required Rate of Return|
R(f)| Risk Free Rate|
R(m)| Market Return|
R(m)-R(f)| Market Premium|
Capital Asset Pricing Model (CAPM):
E(R) = Rf + B(Rm-Rf)
E(R) = 2% + 0.8(12%-2%)
E(R) = 10%
The required rate of return, which is the minimum yield that investors require in order to select a particular investment, was calculated using the CAPM. The CAPM is a model that describes the relationship between risk and return and is calculated using three inputs; risk free rate, beta and the market return.
The risk free rate is a rate of interest which can achieved without any risk of default. The beta is a measure of stock volatility in relation to the stock market and the market return is the return generated by the respective stock market index.
The expected return given by CAPM is based on two underlying factors; time value of money and risk. The risk free rate (Rf), for which a short term government bond is most commonly used, represents the time value of money which is the opportunity cost of taking the risky investment while the second part of the equation (B(Rm-Rf)) represents the risk premium which is the additional return that is expected from the risky investment for taking the risk. As can be seen above, the risk free rate if 2% while the risk premium is 8%. This gives rise to an overall expected/required return on equity of 10%. If Naturally Fresh Plc equity return was lower than the calculated CAPM valuation of 10% return, an investment in the company should be avoided as for the same level of risk one could find other investments providing 10% or better returns on equity.
The beta is simply a measure of systematic risk. It is a measure of stock volatility in comparison to the stock market as a whole, which is used as the benchmark.
The benchmark is assigned a beta of one and so a stock with a beta of more than one exhibits in general proportionately more volatile than the market and this is indicative of a higher risk for which a higher required rate of return will be demanded.
In contrast, a stock with a beta less than one, as is the case with Naturally Fresh Plc, will in general exhibit proportionately less volatile than the market. For example, a 5% increase in the market will result in a 4% (0.8*5%) increase in the share price of Naturally Fresh Plc. Similarly a 5% decrease in market will result in a 4% decrease in the share price of Naturally Fresh Plc. Therefore a beta of 0.8 means that shareholders are better protected from a market downturn however they reap fewer profits from a stock market increase.
3. Capital Asset Pricing Model (CAPM)
3.1 Limitations of CAPM
One of the biggest limitations of the CAPM is...