Landon Stevens is evaluating the expected performance of two common stocks, Furh
ID: 2727227 • Letter: L
Question
Landon Stevens is evaluating the expected performance of two common stocks, Furhman Labs, Inc., and Garten Testing, Inc. The risk-free rate is 5.1 percent, the expected return on the market is 12.0 percent, and the betas of the two stocks are 1.3 and .8, respectively. Stevens’s own forecasts of the returns on the two stocks are 16.20 percent for Furhman Labs and 11.10 percent for Garten. 1. Calculate the required return for each stock. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places. Omit the "%" sign in your response.) Stock Required Return Furhman Labs % Garten Testing % 2. Is each stock undervalued, fairly valued, or overvalued? Furhman Labs Fair valued Undervalued Overvalued Garten Testing Overvalued Undervalued Fair valued
Explanation / Answer
1.
E(r) = r f + [E(r M ) - r f ]
According to the CAPM the expected return on the two stocks should be as follows:
Furhman:
E(r) =5.1+1.3(12-5.1)
=14.07
Garten:
E(r) =5.1+.8(12-5.1)
=10.62
2.
Furhman's CAPM return of 14.07 is lower than Wilson's forecast of 16.20, implying that the stock is undervalued. Garten's CAPM return of 10.62% is lower than Wilson's forecast of 11.16% implying that the stock is undervalued.
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