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Here are data on two companies
Here are data on two companies. The rate is 3%, and the market risk premium is 6%. Company CompanyA CompanyB Forecast return 10( Beta 1.3 0.8
a) OWliffltv) What ‘‘ould be the fair return for each company, according to the capital asset pricing model (CAPM)?
MitifteR) Is the stock of Company A overpriced or underpriced? Why? Is the stock of Company B overpriced or underpriced'? Why?
Expert Solution
Computation of Expected Rate of Return using Capital Asset Pricing Model (CAPM):
For Company A:
Expected Rate of Return = Risk-free Rate + Beta*Market Risk Premium
= 3% + 1.3*6%
= 3% + 7.80%
Expected Rate of Return = 10.80%
For Company B:
Expected Rate of Return = Risk-free Rate + Beta*Market Risk Premium
= 3% + 0.8*6%
= 3% + 4.80%
Expected Rate of Return = 7.80%
The Expected Return for Company A (10.80%) exceeds the Forecast Return (10%), it would be considered as "Overpriced"
The Expected Return for Company B (7.80%) is less than the Forecast Return (8%), it would be considered as "Underpriced"
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