A manager believes his firm will earn a 19.80 percent return next year. His firm

Question

A manager believes his firm will earn a 19.80 percent return next year. His firm has a beta of 1.53, the expected return on the market is 12.60 percent, and the risk-free rate is 5.60 percent.

Compute the return the firm should earn given its level of risk.

Determine whether the manager is saying the firm is undervalued or overvalued.

A manager believes his firm will earn a 19.80 percent return next year. His firm has a beta of 1.53, the expected return on the market is 12.60 percent, and the risk-free rate is 5.60 percent.

Explanation / Answer

Required return (CAPM) = Risk free rate+ Beta*(Market return-risk free return) = 5.6+1.53*(12.6-5.6) = 16.31 Thus, required return is 16.31% Since required return is only 16.31% but firm is expectly earning 19.80%. Thus, manager is saying that his firm is Overvalued.

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