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.

Question

Quizplus · Accepted Answer

The return the firm should earn given its level of risk can be calculated using the Capital Asset Pricing Model (CAPM) formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the given values: Expected Return = 4% + 1.5 * (14% - 4%) = 4% + 1.5 * 10% = 4% + 15% = 19%. Since the manager expects a 16% return, which is less than the 19% calculated, the firm is considered overvalued.

A Manager Believes His Firm Will Earn a 16 Percent