The equity beta of Fence Co is 0•9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7•50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107•14.

The equity beta of Fence Co is 0•9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is $7•50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market value of each bond is $107•14.

The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation tax at a rate of 20% per year.

Required:

Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital asset pricing model. (6 marks)