A manager believes his firm will earn an 18 percent return next year. His firm has a beta of 1.75, the expected return on the market is 13 percent, and the risk-free rate is 5 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued.

Question

Quizplus · Accepted Answer

The correct answer is A because the expected return on the stock should be 19 percent, which is higher than the 18 percent return that the manager believes the firm will earn. This indicates that the manager believes the firm is undervalued.

A Manager Believes His Firm Will Earn an 18 Percent