Question

A manager believes his firm will earn a 16.9 percent return next year. His firm has a beta of 1.59, the expected return on the market is 14.9 percent, and the risk-free rate is 4.9 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued.

Answer 1

Return = 20.8%.

It is overvalued

Step-by-step explanation:

The capital asset pricing model is a risk-based model. Here, the return on equity is dependent on the level of reaction of the the equity to changes in the return on a market portfolio. These changes are captured as systematic risk. The magnitude by which a stock is affected by systematic risk is measured by beta.

Under CAPM, Ke= Rf + β(Rm-Rf)

Rf-risk-free rate (treasury bill rate), β= Beta, Rm= Return on market.

Rf- 4.9% , Rm- 14.9%, β-1.59

Using this model,

Ke= 4.9% + 1.59×(14.9%-4.9%)

= 20.8%

Return = 20.8%.

The CAPM is greater than the expected return, hence the firm is overvalued