Landon Stevens is evaluating the expected performance of two common stocks, Furh

Question

Landon Stevens is evaluating the expected performance of two common stocks, Furhman Labs, Inc., and Garten Testing, Inc. The risk free rate is 5.8 percent, the expected return on the market is 13.4 percent, and the betas of the two stocks are 2.0 and 0.9, respectively. Stevens's own forecasts of the returns on the two stocks are 1760 percent for Furhman Labs and 11.80 percent for Garten. a. Calculate the required return for each stock. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Stock Furhman Labs Garten Testing Required Return b. Is each stock undervalued, fairly valued, or overvalued? Furhman Labs OOvervalued OUndervalued Fair valued Garten Testing Overvalued Undervalued OFair valued

Explanation / Answer

As per CAPM Model ra = rrf + Ba (rm-rrf) where: ra = Rate of return from the asset rrf = Rrate of return for a risk-free security rm = Broad market's expected rate of return Ba = beta of the underlying asset (equity) Given Markert Return (rm) 13.40% Furhman Lab INC Beta 2 Garten Testing Inc Beta 0.9 Risk Free return rrf 5.80% Furhman lan Inc return =5.80%+(2x(13.4%-5.80%)) Furhman lan Inc return 21.00% Garten Testing Inc Return =5.80%+(0.9x(13.4%-5.80%)) Garten Testing Inc Return 12.64% Stevens Forecast Furhman lan Inc return 17.60% Garten Testing Inc Return 11.80% If the expected return on a stock derived using CAPM is lesser than than predicted returns it is under valued If the expected return on a stock derived using CAPM is more than than predicted returns it is Over valued Furhman lan Inc return CAPM return > Predicted returns so - Over valued Garten Testing INC CAPM return

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