Question

I am buying a firm with an expected perpetual cash flow of $650 but am unsure of its risk. If I think the beta of the firm is zero, when the beta is really 1, how much more will I offer for the firm than it is truly worth? Assume the risk-free rate is 5% and the expected rate of return on the market is 13%

Answer 1

Actual required rate:

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 5 + 1 * (13 - 5)

Expected return% = 13

Assumed required rate

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 5 + 0 * (13 - 5)

Expected return% = 5

Extra amount offered = perpetual cf/assumed rate-perpetual CF/expected rate

=650/0.05-650/0.13= 8000