McKinley Investment Partners (MIP), a diversified investment firm based in Salt Lake City, USA, is considering increasing its investment in the North American transportation sector. Douglas Gast, portfolio manager at MIP, states that although the railroad industry is quite cyclical, it is a good time to invest in this sector as improved economic activity in the USA will have a positive impact on the railroad industry’s profitability relative to the S&P 500. Gast has assigned Gary Hughes, an associate analyst, the task of analyzing rail companies and presenting his recommendation the following week.
Hughes is initially interested in determining the required return on equity for the rail company of interest. He considers several methods that can be utilized for this purpose and makes the following notes:
· The capital asset pricing model (CAPM) captures company specific and market risk. · The Fama-French model includes factors that measure size and value. · The bond yield plus risk premium method incorporates the yield to maturity of a company’s debt.
After considering these alternative methods, Hughes selects the Fama-French model as his preferred method. His first determination is for Western Plains Rail (WPR), using the data presented in Exhibit 1.
Exhibit 1
Selected Market Data for Western Plains Rail
Factor Sensitivity
Risk Premium (%)
Market factor 1.3
5.2
Size factor -0.2
2
Value factor -0.3
4.3
Liquidity factor 0.1
3.7
Current short-term government bill yield 1.2%
Current long-term government bond yield 4.1%
Using the data in Exhibit 1 and Hughes’ preferred method, the required return on equity for Western Plains Rail is closest to:
A.9.2%.
B.6.6%.
C.6.3%.
I thought A was the answer as I used long term govt bond yield as the curriculum states that long term govt bonds are preferred over bills? But the curriculum used the short term bill rate in the answer. Can anyone please explain why?