Additional information:

The long term market risk premium can be assumed to be $4\mathrm{.}0\%.$

The risk free rate is $1\mathrm{.}0\%.$

Corporate income tax is charged at $35\%.$

Debt betas for both $P$&$T$ and $T$&$T$ can be assumed to be zero.

Required:

$($a$)$ Calculate a WACC for $P$&$T$ using $T$&$T\text{'}$s beta.

$($b$)$ Write a report to the Managing Director, advising P & T on the benefits and drawbacks of

using the WACC calculated in part $($a$)$ above as the discount rate in investment appraisal. $[7]$

$($c$)$ Explain:

i$.$ The difference between systematic and unsystematic risk.

ii$.$ The components of the CAPM formula.

iii. The theoretical relationship between these components shown by the CAPM formula.QUESTION $3[25$ MARKS$]$

$P$&$T$ is a private manufacturing company. The company owns patents for certain luxury skin

care products which it manufactures and sells to the wholesale market. It is also actively

involved in research and development $($R&D$)$ of new products. P & T has a pre$-$tax cost of debt

of $3\mathrm{.}0\%$ and gearing $($debt$/$debt $+$ equity$)$ of $40\%,$ based on its best estimate of the market values

of debt and equity.

$P$&$T$ is currently considering a number of different possible investment projects, proposed by

both the R&D and manufacturing departments.

When evaluating proposed investments, P & T has previously always used a discount rate of

$10\%$ to discount expected future cash flows. However, the new Financial Director $($FD$)$ has

challenged this and has suggested that the company should derive a weighted cost of capital

$($WACC$)$ using the capital asset pricing model $($CAPM$).$ This WACC could then be used as the

discount rate in future investment appraisal decisions. The Managing Director $($MD$)$ has asked

the FD to justify this proposal and to calculate a more appropriate WACC for P & T$.$ The FD

of $P$&$T$ has identified a company, $T$&$T,$ which operates in the same industry. $T$&$T$ has an

equity beta of $2\mathrm{.}4$ and gearing $($debt$/$debt $+$ equity$)$ of $30\%$ based on market values.