Question

Reddi Plc is a car manufacturer. Reddi shares have a beta of 0.9. A security analyst who specialises in studying car manufacturers expects its return to be 13%. Suppose that the risk free rate is 8% and the market-risk premium is 6%. Is the analyst pessimistic or optimistic about this firm relative to the market’s expectations? Support your answer with appropriate calculations.

Answer 1

Risk free rate of return = 8%
Market Risk Premium = 6%
Beta of Reddi's Share = 0.9

As per CAPM model

Return of stock  = Rf + Beta (Rm - Rf)
Where Rf = Risk free return
Rm - Rf = Market risk Premium

Return of stock  = 8% + 0.9 * 6%
Return of stock  = 13.4%

Decision: Is the analyst pessimistic or optimistic about this firm relative to the market’s expectations?

Expected Return = 13%
CAPM Return = 13.4%

Since, CAPM return > Expected return, it means that the stock is overvalued. This indicates that the analyst is optimistic about this firm relative to the market’s expectations