FM – July 2025 – L2 – Q1 – Cost of capital, CAPM & Islamic finance

Application of CAPM and WACC, project risk adjustment using beta, Islamic finance options, and indicators of company success.

Question

a) Agado Pharmaceuticals, a leading company in the pharmaceutical industry, is considering expanding into digital health and telemedicine, a new area that differs from its current operations. Digital health and telemedicine involve the use of technology to deliver healthcare services and manage patient care remotely.

The company currently has an equity beta of 0.9 and has issued 10,000,000 ordinary shares. The market value of each ordinary share is GH¢7.50. In addition to equity financing, Agado Pharmaceuticals is also financed by 7% irredeemable bonds, with a nominal value of GH¢100 per bond. The bonds have a total nominal value of GH¢14,000,000. Interest on the bonds has recently been paid and the current market value of each bond is GH¢107.14.

As part of its strategic expansion, Agado Pharmaceuticals is evaluating a potential investment in a project aligned with the business operations of Konte LTD, a company that operates in digital health. Konte LTD has an equity beta of 1.2.

Given the financial landscape, the risk-free rate of return is 4% per year and the average stock market return per year is 11%. Both companies are subject to a 25% corporate tax rate.

Required:

i) Using Capital Asset Pricing Model (CAPM), estimate the cost of equity for Agado Pharmaceuticals.

ii) Calculate the Weighted Average Cost of Capital for Agado Pharmaceuticals.

iii) Estimate the cost of equity which could be applied in evaluating the new project using Konte’s equity beta.

iv) Explain TWO Islamic finance sources that Agado Pharmaceuticals could consider as alternatives to equity or debt financing.

b) Finance Managers of companies play a pivotal role in steering an organisation towards success by managing financial resources and aligning financial objectives with the organisation’s technological and market goals.

Required:

Explain FIVE factors that are indicative of a company’s success.

Answer

a)

i) Cost of equity using the Capital Asset Pricing Model (CAPM)

Rf = 4%, Rm = 11%, β = 0.9

Cost of equity = 4 + (0.9 × (11 − 4))
= 4 + 6.3
= 10.3%

ii) Weighted Average Cost of Capital (WACC)

After-tax cost of debt:

Interest = 7% × GH¢100 = GH¢7

$kdt=7(1−0.25)107.14=4.9%k_{dt} = \frac{7(1 – 0.25)}{107.14} = 4.9\%$

Market values:

Market value of equity (Ve):
10,000,000 × GH¢7.50 = GH¢75,000,000

Market value of debt (Vd):

$GH¢14,000,000GH¢100×GH¢107.14=140,000×GH¢107.14=GH¢14,999,600\frac{GH¢14,000,000}{GH¢100} \times GH¢107.14 = 140,000 \times GH¢107.14 = GH¢14,999,600$

Total market value = GH¢89,999,600

$\frac{75,000,000}{89,999,600} \times 10.3\% + \frac{14,999,600}{89,999,600} \times 4.9\% = **9.4\%**$

(5 marks)

iii) Cost of equity for the new project using Konte LTD’s beta

Rf = 4%
Rm = 11%
β = 1.2

Cost of equity = 4 + 1.2 × (11 − 4)
= 4 + 8.4
= 12.4%

The appropriate cost of equity to appraise the new project is 12.4%.

iv) Islamic finance sources

Islamic financial instruments include:

Murabaha – A credit sale arrangement where goods are sold at a pre-agreed mark-up instead of charging interest.
Ijara – A leasing arrangement where the lessor retains ownership and responsibility for the asset while the lessee pays rent.
Mudaraba – A partnership where one party provides capital and the other manages the business, with profits shared and losses borne by the investor.
Musharaka – A joint partnership where all parties contribute capital and expertise, sharing profits and losses.
Sukuk – Shariah-compliant bonds representing ownership in an asset, with returns derived from asset income rather than interest.

b) Factors indicative of a company’s success

Consistent and sustainable revenue growth
High gross and net profit margins
Positive operating cash flows
Low debt relative to equity
Adequate working capital
Predictable earnings
Reasonable and consistent dividend payments

Tags: CAPM, Corporate Performance Indicators, Cost of Capital, Cost of Equity, Islamic Finance, WACC
Level: Level 2

Topic: CAPM, Corporate success factors, Cost of capital, Islamic Finance
Series: JULY 2025

Uploader: Samuel Duah