Question

Landon Stevens is evaluating the expected performance of two common stocks, Furhman Labs, Inc., and Garten Testing, Inc. The risk- free rate is 5.0 percent, the expected return on the market is 11.8 percent, and the betas of the two stocks are 1.2 and 0.7 respectively. Stevens's own forecasts of the returns on the two stocks are 16.00 percent for Furhman Labs and 11.00 percent for Garten a. Calculate the required return for each stock. (Do not round Intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Required Return Stock Furhman Labs Garten Testing b. Is each stock undervalued, fairly valued, or overvalued? Futhman Labs Undervalued Overvalued Fair valued

Answer 1

Ans(a)

Calculation of Required Rate of Return for Furhman Labs=Risk free rate of return+Beta(Market Rate of Return-Risk Free rate of return)

=5+1.2(11.8-5)

=5+1.2(6.8)

=5+8.16

=13.16

Where as Required rate of return for Garten=

=5+0.7(11.8-5)

=5+0.7(6.8)

=5+4.76

=9.76

Hence, Required rate of return for Furhman Labs is 13.16% and for Garten Testing is 9.76%.

Further Furhman and Garten both stocks has been over valued by the Steven as expectation of Steven higher than the required rate of return on both the stocks.