Rio Tinto Group CAPM and dividend policy

Running head: CORPORATE FINANCE 1
Rio Tinto Group CAPM and dividend policy models
Name of the student
Institutional affiliation
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CORPORATE FINANCE 2
Introduction
The paper is an assessment regarding the financial aspects of the capital asset pricing
model together with the dividend policy model of a firm. As required, the selected company for
making the analysis is known as Rio Tinto Group. Briefly, Rio Tinto is an Anglo-Australian
multinational entity dealing mining and metals. The company also has its headquarters located
in the United Kingdom, London and it is also listed on the London stock exchange as RIO
(ASX). Therefore, for the purposes of making the CAPM analyses Rio Tinto will be used as the
case study. The structure of the paper comprises of four main sections in which all the required
assessments are provided. For instance in the first section of the paper, calculations regarding
the CAPM are provided. Besides the calculations, the section also includes other elaborate
explanations about the various aspects of CAPM.
The capital asset pricing model refers to a financial approach through which the
relationship between systematic risk and expected returns is analyzed. Majorly, the technique is
used to evaluate stock returns hence its applicability to the selected company of choice.
Primarily, investors and stock holders use the capital asset pricing model to forecast the required
rate of return of any given stock or asset. To effectively make such forecasts of the expected
return, three major factors are put into play. These include the risk free rate of the stock, the
expected market return and the beta value of the asset. Regarding the riot into group, the Capital
Asset Pricing Model is calculated as below with consideration of all the above mentioned
factors:
A): Calculating The Company’s Current Cost of Equity Using the Capital Asset Pricing
Model

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As previously mentioned, the capital asset pricing model a measure used to determine
and assess the expected return of an asset, security or stock. In the financial market different
securities have varying levels of risk attached. Due to such a scenario investors are tend to draw
closer attention to the risks associated with particular stocks or assets on the market. Some of the
stocks are highly risky whereas others have low levels of risks attached. It should however be
noted that the highly risky securities also have high levels of return (Boyte-White, 2020). On the
other hand, assets that have low risks have low returns as well. Therefore, to determine the
riskiness of an asset, investors apply the Capital asset pricing model.
On the other hand however, public listed companies seek to raise capital by issuing out
shares on the stock market. It is such a factor that gives rise to the concept of cost of equity of a
firm. Under normal circumstances, a public listed entity uses two main sources of capital and
these include the debt finance ordinary share financing. Therefore where an entity opts to use
equity financing, then this give s rise to the cost of equity. Alternatively, the cost of equity is
also known as the expected return on an investment especially for the shareholder. When using
the capital asset pricing model, the cost of equity also represents the current cost of equity of a
firm. Since the investor or ordinary share holder aims at generating returns, the company is
deemed to declare dividends. It is these dividends that are characterized as the cost of equity.
The capital asset pricing (CAPM) is therefore given by the formula stated as:
E (r) =r f + β ¿ ¿)
According to the above formula, E(r) is the known as the expected return of an asset. r f
on the other hand represents the risk free rate of the asset or stock. The β factor on the other

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hand shows the level of systematic risk of the stock. rm is the expected market return of the stock
or security and in this case, riot into is the security of interest.
The CAPM model can however be subdivided into two main parts to include the risk
free rate section and the risk premium (Rio Tinto Plc, 2017). The risk premium component
comprises of the stock’s beta multiplied by the difference between the market risk and the risk
fee rate of the stock. It is this component of the formula that determines the overall risk of the
stock is then obtained. Assuming that an investor is interested in the determining the market
return of Rio Tinto for the past six months, then the following calculation is applied.
Expected market return of Rio Tinto Group for six months would be determined as
follows: market return for 6 months = v1−v0
v0
* 100. Where v1 is the current stock price and v0 as
the starting price per share (Martin and Wagner, 2019). Therefore, to obtain the expected market
return of riot into group for six months the above formula is applied to the stock.
Market return (rm) = 45.58−45.51
45.51 * 100
= 0.08
45.51 * 100
= 0.1758% ≈ 0.2 %
Therefore in the last six months Rio Tinto Group has an average market return of about 0.2%.
The beta value of the stock for Rio Tinto Group is about 0.86 as obtained from yahoo finance in
the same period. It should be noted that beta is an indication of the level of riskiness associated
with an asset. In the market however, all stocks that have beta values exceeding 1 are deemed to
be highly risky (ACCA, 2020). Since Rio Tinto has a beta lower than 1, then it is relatively a
safe stock or asset. To determine the risk free rate, investors normally subtract the rate of

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inflation from the rate of return generated by the yield of a treasury bond in the same period.
Therefore assuming that Rio Tinto has a treasury bond with a yield rate of 8.65%, then the risk
free rate can be determined by Lessing the inflation rate in London from the above 8.65%. From
the office of the national statistics, inflation in London is rated around 1.8%. Therefore the risk
free rate of the stock is also obtained as: (8.65-1.8) %. Therefore, the risk free rate of the stock is
obtained as 6.85%. Given the above statistical figures, then the cost of equity for Rio Tinto
Group can be calculated as follows:
Cost of equity for Rio Tinto Group = E (r) =r f + β ¿ ¿). Since the values have been obtained as
explained above, then they can be substituted into the formula to determine Rio Tinto’s Cost of
equity while using the CAPM technique.
Where: rf = 6.85%
Rm = 0.2%
β = 0.8
So, the cost of equity is determined as; E(r) = 6.85% +0.8 (0.2-6.85)
= 6.85% + -5.32%
E(r) =1.5%
Therefore, the current cost of capital (expected return on investment) for Rio Tinto Group
is about 1.5% for the past six months as per the capital asset pricing model. Since the asset is
associated with a low level of risk, then the expected return or cost of equity is also low at only
about 1.5%. It should therefore be noted that the higher the risk of a stock or a security, the
higher the level or return or cost of equity.
B): Ungearing the Company’s Equity Beta to Derive Its Asset Beta
An asset’s equity beta is used to represent both the financial and business risk of an asset
or stock. It is therefore a technique through which the volatility of an asset is measured as
compare to the general market performance (ACCA, 2020). Stocks with high equity betas that

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are greater than one are classified as highly volatile in the market. The asset beta also known as
the leveraged beta of a stock on the other hand represents the market risk of a stock without
taking into consideration the effects of debt. In other words, asset beta of a company is used to
create comparisons between the volatility of a given stock against the general market. In
computing or ungearing the equity beta ti form determine the asset beta, the following approach
is applied.
βa =
βe
1+ ( 1−t ) D
E
In the above formula, βarepresents the asset beta of a company, βe on the other hand is
the firm’s equity beta. In the Rio Tinto case, the equity beta is given as 0.8. (1-t) is the prevailing
tax rate and D
E is the debt-to-equity ratio of the company. Alternatively, asset beta can also be
obtained through the following technique. Asset beta = βe∗vd∗(1−t )
ve +vd∗(1−t) + βe∗ve
ve∗(1−t). Where: ve is
the market value of the company’s shares and vd is the market value of the company’s debt.
For this particular paper however, the first formula will be used to Ungear Rio Tinto’s
asset beta and it is calculated as follows:
Therefore, given that βa =
βe
1+ ( 1−t ) D
E
βe= 0.8
t = 0.190
Debt (D) =13.34 billion
Equity (E) = 45.24 billion