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Patricia Franklin makes buy and sell stock recommendations using the capital asset pricing model. Franklin has derived the following information for the broad market and for the stock of the CostSave Company (CS):
Expected market risk premium 8%
Risk-free rate 5%
Historical beta for CostSave 1.50
Franklin believes that historical betas do not provide good forecasts of future beta, and therefore uses the following formula to forecast beta:
Forecasted beta = 0.80 + 0.20 * historical beta
After conducting a thorough examination of market trends and the CS financial statements, Franklin predicts that the CS return will equal 10%. Franklin should derive the following required return for CS along with the following valuation decision (undervalued or overvalued):
Valuation CAPM required return
A. overvalued 8.3%
B. overvalued 13.8%
C. undervalued 8.3%
D. undervalued 13.8%
Answer:B
Franklin forecasts the beta for CostSave as follows:
beta forecast = 0.80+0.20 (historical beta) = 0.80 + 0.20(1.50) = 1.10
The CAPM required return for CostSave is: 0.05 + 1.1(0.08) = 13.8%
Frankiin should decide that the stock is overvalued because she forecasts that the CostSave return will equal only 10%, whereas the required return (minimum acceptable return) is 13.8%.
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