Question

reg Noronha has been told the expected return on Merchants Bank is 7.00%, He knows the risk-free rate is 2.10%, the market risk premium is 6.45%, and Merchants' beta is 0.78. Based on the Capital Asset Pricing Model, Merchants Bank is:

Answer 1

Answer:

As the required rate of return of the Merchants bank (7.131%) is more than its expected return of (7%), the Merchants Bank is overvalued/overpriced.

Explanation:

Using the CAPM, we can calculate the required rate of return on a stock. This is the minimum return required by the investors to invest in a stock based on its systematic risk, the market's risk premium and the risk free rate.

The formula for required rate of return under CAPM is,

r = rRF + Beta * rpM

Where,

• rRF is the risk free rate
• rpM is the market risk premium

r = 0.021 + 0.78 * 0.0645

r = 0.07131 or 7.131%

As the required rate of return of the Merchants bank (7.131%) is more than its expected return of (7%), the Merchants Bank is overvalued/overpriced.