Question 2

You are considering investing in Varco plc and have decided to calculate the value of the company using some of the techniques you have covered in your University course. After a considerable amount of research you have decided that an appropriate risk free rate of return is 6.5% and the market rate of return is 12%.

You have also found various financial web sites that have given you an average beta of 1.9.

Required:

a) Discuss why knowing a company’s beta is important when making an investment decision. (You should relate your answer to Varco plc.)

b) Use the capital asset pricing model (CAPM) to calculate the expected return of Varco’s equity.

c) Discuss the theoretical and practical difficulties in using the CAPM to calculate the expect return on a particular share.

d) In the context of the CAPM explain what is understood by the Security Market Line (you may find that drawing a diagram helps here) and what would happen if a share was not on the Security Market Line.