Question

What is the difference between the required rate of return and the expected rate of return?

According to the scenario using the analysis of the current growth model for the required rate of return and the excepted rate of return we were asked if we could give the investors a 15% return CAPM We used beta as an estimate number which gave us a benchmark TF wanted to know the value of their stock and keep in mind admin changes We used the constant growth model to determine the share price We were given present value of all future ash flows the variables given were: Dividends flat rate $10 Growth Rate (g) 10% Required Rate on Return 15% Using the Constant Growth Model: (10*(1+10)/ (.15-.10) = $220 per share of stock compare to the days current trading $220.65. To determine if stock value is undervalued or overvalued we use CAPM= Rf+B (Rm-Rf) = 3% + .8 (15%-3%) = 12.6 Making it UNDERVALUED

Answer 1

Required rate of return is the return an investor requires for investing in an asset. It is based on inherent risk of the investment. It also depends on the risk aversion of the investor.

Expected rate of return is the expected return an investment would provide. It is calculated on the basis of CAPM. It is the return the market would require on an investment on the basis of the risk of the investment.

As per the calculation price of stock would be 10*(1+0.10)/(0.15-0.10)=$220
Since the current price of stock is $220.65 it is slightly OVERVALUED.

If CAPM return is 12.6% and the required return is 15%, then the stock shall be again OVERVALUED because it provides lesser return than required return.