Question

A manager believes his firm will earn a 16 percent return next year. His firm has a beta of 1.5. The expected return on the market is 14 percent, and the risk-free rate is 4 percent. Compute the return the firm should earn given its level of risk, and determine whether the manager is saying the firm is undervalued or overvalued relative to their own estimate.

Answer 1

Using the Capital Asset Pricing Model (CAPM), the expected rate of return for the firm with a beta of 1.5, risk-free rate of 4%, and market return of 14% is calculated to be 19%. The manager's belief that the firm will earn a 16% return suggests that the firm could be considered undervalued according to CAPM, as the expected return given its level of risk is higher.

Step-by-step explanation:

To compute the return that the firm should earn given its level of risk, we can use the Capital Asset Pricing Model (CAPM). The formula for CAPM is:

Expected Return = Risk-Free Rate + (Beta * (Market Return - Risk-Free Rate))

Given the provided information:

Risk-Free Rate = 4%

Beta = 1.5

Expected Market Return = 14%

We can calculate the expected rate of return for the firm:

Expected Return = 4% + (1.5 * (14% - 4%))

Expected Return = 4% + (1.5 * 10%)

Expected Return = 4% + 15%

Expected Return = 19%

The manager believes the firm will earn a 16 percent return next year, which is lower than the calculated expected rate of return of 19% given the firm's beta of 1.5. Therefore, based on the CAPM and assuming the market conditions and beta remain stable, the firm might be considered undervalued relative to the manager's estimate.

Answer 2

19%

Overvalued

Step-by-step explanation:

Computation for the return the firm should earn

Using this formula

The firm's required return=Risk-free rate+Beta×( Expected return-Risk-free rate)

Let plug in the formula

The firm's required return = 4% + 1.5 x (14% - 4%)

The firm's required return =4%+1.5×10%

The firm's required return =0.19*100

The firm's required return =19%

Based on the above calculation the firm's required return is 19% in which the manager believes a 16% return will be achieved which means that manager is saying the firm is OVERVALUED relative to their own estimate.