Question

Greg Noronha has been told the expected return on Merchants Bank is 7.00%, He knows the risk-free rate is 2.10%, the market risk premium is 6.45%, and Merchants' beta is 0.78. Based on the Capital Asset Pricing Model, Merchants Bank is:

Answer 1

Merchants Bank is overvalued

Step-by-step explanation:

In the first, we need to determine the required rate of return on Merchant Bank stock using the Capital Asset Pricing Model formula for the required rate of return found below:

The required rate of return=risk-free rate+beta*market risk premium

risk-free rate=2.10%

beta=0.78

market risk premium=6.45%

The required rate of return=2.10%+(0.78*6.45%)

the required rate of return=7.13%

Since the expected return(discount rate) used in valuing Merchant Bank is lower viz-a-viz the required rate of return of 7.13%, the stock is said to overvalued