Question

The risk-free rate is 7% and the expected rate of return on the market portfolio is 11%. a. Calculate the required rate of return on a security with a beta of 1.92. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) b. If the security is expected to return 15%, is it overpriced or underpriced?

Answer 1

Required rate of return= 14.8

If the security is expected to return 15%, it is underpriced.

Step-by-step explanation:

The required rate of return on the security can be calculated using the CAPM formula which states that

Required rate of return =rf + B(rm - rf)

where rf= risk free rate

B= beta of the security

rm = return on the market

Required rate of return =
`0.07 + 1.92(0.11-0.07)` = 14.68%

If the security is expected to return 15%, it is underpriced, and is a good investment. Discounting the expected cash-flows from the security at this higher expected return of 15% is going to yield a lower price compared to what the investor is prepared to pay given his required rate of return of 14.68%.