Question

Suppose that you have the following information about Firm K: P, = $49, ê, = $52.50, D, = $2.15 Bx = 0.92, Market Risk Premium = 6.5%, R, = 1.5% Is Firm K's stock overvalued, correctly priced, or undervalued? Support your answer with calculations and explain.

Please show all work! Correct answers are:

Required Return= 7.48%, Expected Return = 11.53%, so undervalued

Answer 1

The required return is computed as shown below:

= Risk free rate + Beta x Market risk premium

= 0.015 + 0.92 x 0.065

= 7.48%

The expected return is computed as shown below:

= ( P1 - P0 + D1 ) / P0

= ( $ 52.50 - $ 49 + $ 2.15 ) / $ 49

= 11.53% Approximately

Whenever the expected return is greater than the required return, the stock is considered to be undervalued

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