A manager believes his firm will earn a 10.87 percent return next year. His firm

Question

A manager believes his firm will earn a 10.87 percent return next year. His firm has a beta of 1.01, the expected return on the market is 11.30 percent, and the risk-free rate is 5.30 percent.

Compute the return the firm should earn given its level of risk. (Round your answer to 2 decimal places.)

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

A manager believes his firm will earn a 10.87 percent return next year. His firm has a beta of 1.01, the expected return on the market is 11.30 percent, and the risk-free rate is 5.30 percent.

Explanation / Answer

Answer a.

Beta = 1.01
Market return = 11.30%
Risk-free Rate = 5.30%

Required Rate of Return = Risk-free Rate + beta * (Market Return - Risk-free rate)
Required Rate of Return = 5.30% + 1.01 * (11.30% - 5.30%)
Required Rate of Return = 11.36%

Answer b.

Manager is saying the firm is over-valued as required rate of return is higher than expected return during next year.

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