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CAPM formula shows the linear relationship between the return required on an investmentand its expected risk.RE=rf+E(rm)−rf¿βRE= 3.88%+ 0.86(18.13% - 3.88%)= 16.135%Where,rfrefers to the risk free rate and its value is denote as the Malaysia Government 10Year Bond. ()βrefers to the Beta of SOP shares and its value is denote from Reuters.com. ()Page | 11
FNCE3000 Corporate FinanceSemester 1, 2015E(rm)refers to the market rate of return and its value is denote as index point and later change to %. ()E(rm)−rf¿refers to the market risk premium and its value is denote by subtracting market return and risk free rate.00.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.910.00%2.00%4.00%6.00%8.00%10.00%12.00%14.00%16.00%18.00%Security Market LineRequire rate of returnLinear (Require rate of return)BETA of SOP SharesRETURNThe above graph shows the Security market line (SML) of SOP stocks, the line shows thereturn on a given investment in relation to SOP shares risk. The risk is measured using beta.The line begins with the risk-free rate with zero risk/ beta at 3.88% and moves upward to theright. As the risk of an investment increases, it is expected that the return on an investmentwould increase. The expected return on equity of SOP with a beta of 0.86 falls at 16.14% asshown on the SML graph. In general, investor with a low risk profile or risk adverse wouldchoose an investment at the beginning of the security market line. While investor with ahigher risk profile or risk taker would select their investment to be higher along the securitymarket line.Page | 12
FNCE3000 Corporate FinanceSemester 1, 2015The other method of calculating cost of equity is through Dividend Growth Model (DGM).DGM is a valuation method which takes into consideration dividend per share and itsexpected growth. DGM can also be known as the Dividend Discount Model or the GordonGrowth model. It is the key valuation technique for dividend stocks. There are two types ofDGM methods of calculating the cost of equity and one of them is the Constant DividendGrowth Model, and also the Multistage Growth Model.The general DGM formula is expressed as: P0=D1/Ke−gRE=D1P0+gTo calculate Growth rate (g):g=D1D0−1=D13D12−1=0.060.05−1=0.2 or 20%To calculate D1: D1=D0(1+g)D14=D13(1+g)= 0.06 (1+0.2)Page | 13
FNCE3000 Corporate FinanceSemester 1, 2015= 0.072Hence, RE=D1P0+g¿D14P13+g¿0.0725.09+0.2= 0.214 or 21.4%Where, D is the dividend on the particular year, for example D13represent dividend in year 2013. The value is taken from annual report.RErefer to the required rate of return on equity. P is the price of shares in the particular year, for example P13represent price of share in year 2013. ().As demonstrated by both methods, the results are 5 % gap difference with CAPM generates16.135% while DGM generates 21.4%. This may shows DGM more appealing because of itsmuch higher required rate of return than CAPM. However, judging from the annual reportdividend on 2014 is rather less than or doesn’t change from the dividend in 2013 that is 0.06.