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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 relative to their own estimate.

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abiolataiwo2015

Answer:

19%

Overvalued

Explanation:

Computation for the return the firm should earn

Using this formula

The firm's required return=Risk-free rate+Beta×( Expected return-Risk-free rate)

Let plug in the formula

The firm's required return = 4% + 1.5 x (14% - 4%)

The firm's required return =4%+1.5×10%

The firm's required return =0.19*100

The firm's required return =19%

Based on the above calculation the firm's required return is 19% in which the manager believes a 16% return will be achieved which means that manager is saying the firm is OVERVALUED relative to their own estimate.

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