Question

Landon Stevens is evaluating the expected performance of two common stocks, Furhman Labs, Inc., and Garten Testing, Inc. The risk- free rate is 5.4 percent, the expected return on the market is 12.6 percent, and the betas of the two stocks are 1.6 and 0.8, respectively. Stevens's own forecasts of the returns on the two stocks are 16.80 percent for Furhman Labs and 11.40 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? Furhman Labs Overvalued Undervalued Fair valued Garten Testing Undervalued Overvalued Fair valued

Answer 1

a) Required return, RR = Risk free rate + Beta * (Market return - Risk free rate) Required return of Stock Furhman Labs = 5.4% +1.6* (12.6% - 5.4%) = 5.4% +1.6 * 7.2% = 5.4% +11.52 % = 16.92 % Required return of stock Garten testing Inc., = 5.4%+0.8 * ( 12.6% - 5.4%) = 5.4% +0.8 * 7.2% = 11.16 % b) Furhman Labs Required return = 16.92% Forecast return = 16.80% Since required return is more than estimated return, stock is Overvalued. Garten testing Required return = 11.16% Forecast return = 11.40% Since required return is less than estimated return, stock is undervalued.