Question

A manager believes his firm will earn a 16 percent return next year. His firm has a beta of 1.5. The expected return on the market is 14 percent, and the risk-free rate is 4 percent. Compute the return the firm should earn given its level of risk, and determine whether the manager is saying the firm is undervalued or overvalued relative to their own estimate.

Answer 1

Answer:

19%

Overvalued

Explanation:

Computation for the return the firm should earn

Using this formula

The firm's required return=Risk-free rate+Beta×( Expected return-Risk-free rate)

Let plug in the formula

The firm's required return = 4% + 1.5 x (14% - 4%)

The firm's required return =4%+1.5×10%

The firm's required return =0.19*100

The firm's required return =19%

Based on the above calculation the firm's required return is 19% in which the manager believes a 16% return will be achieved which means that manager is saying the firm is OVERVALUED relative to their own estimate.