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In: Finance

A firm is currently priced at P0 = $30 per share. Beta is 1.25, expected rate...

A firm is currently priced at P₀ = $30 per share. Beta is 1.25, expected rate of return on the market portfolio is 12%, and the risk-free rate of return is 4%. The firm has Jensen’s alpha of (-2%).

Find the expected rate of return the firm should have from the CAPM equation.

Find the expected rate of return the firm happens to have, given your answer in part (a) and given alpha

Is the firm’s stock priced correctly, overpriced, or underpriced?

If the firm is priced at $30 today, and given also your answer in part (b), what is the expected price of the stock next year?

Expert Solution

a.

Expected rate of return of firm as per CAPM equation = R_f + β_i (R_m - R_f)

R_f = risk-free rate = 4%

β_i = Beta = 1.25

R_m = expected rate of return on the market portfolio = 12%

Expected rate of return of firm = 4% + 1.25 (12%-4%) = 14%

b.

Expected rate of return the firm happens to have = Expected rate of return of firm as per CAPM + Jensen’s alpha

= 14% + (-2%) = 12%

c.

The firm’s stock is overpriced

Reason :

Jensen’s alpha is used to determine is firm is giving expected return and a negative alpha means the firm is not giving proper return and firm is under performed and which means the actual price should have been less than what it is and firm is overpriced at current levels.

Considering actual price is based on expected return as per CAPM model but Jensen’s alpha being negative indicates that firm is not giving enough return for its risk level and should be priced lesser than what it is.

d.

Expected price of the stock next year = Current price * (1+expected rate of return)

= 30 * (1+12%) = 33.6

Summary

a. expected rate of return the firm should have from the CAPM equation = 14%

b. Expected rate of return the firm happens to have = 12%

c. The firm’s stock is overpriced

d. Expected price of the stock next year = 33.6

jeff jeffy answered 2 hours ago

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