You are considering acquiring a firm that you believe can generate expected cash

Question

You are considering acquiring a firm that you believe can generate expected cash flows of $12,000 a year forever. However, you recognize that those cash flows are uncertain. a. Suppose you believe that the beta of the firm is .6.

a. How much is the firm worth if the risk-free rate is 3% and the expected rate of return on the market portfolio is 8%? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Value of the firm $

b. By how much will you overvalue the firm if its beta is actually 1.0? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Overvaluation $

Explanation / Answer

A) Expected return = Risk free return + Beta ( Market Return - Risk free return )

= 3%+0.60(8%-3%) i.e 6%

Worth of the firm = 12000/6% i.e 200000

B) Expected return = market return when the beta is exactly 1

Worth of the firm = 12000/8% i.e 150000

Worth of the firm will be reduced by 50000

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