Question

Under/Over Valued Stock A manager believes his firm will earn a 17.3 percent return next year. His firm has a beta of 1.63, the expected return on the market is 15.3 percent, and the risk-free rate is 5.3 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

Beta = 1.63
Market Return = 15.30%
Risk-free Rate = 5.30%

Expected Return = Risk-free Rate + Beta * (Market Return - Risk-free Rate)
Expected Return = 5.30% + 1.63 * (15.30% - 5.30%)
Expected Return = 5.30% + 1.63 * 10.00%
Expected Return = 5.30% + 16.30%
Expected Return = 21.60%

The return required for the level of risk is 21.60% and the manager believes a return of 17.30%.
So, the manager is saying the firm is over-valued (Expected Return is lower than Required Return)