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CMA Intermediate · Financial Management and Business Data Analytics · Risk and Return

Using CAPM, the risk-free rate is 7%, the market return is 15% and the beta of Sundaram Auto's share is 1.25. The share is expected by analysts to return 16%. Based on the CAPM required return, the share is:

The share is overvalued. CAPM required return is 7% + 1.25 × (15% − 7%) = 17%, while the expected return is only 16%. A share offering less than its required return lies below the security market line and is overpriced.

  1. AUndervalued, since expected return 16% exceeds required return 17%
  2. BOvervalued, since expected return 16% is below required return 17%Correct
  3. CUndervalued, since expected return 16% exceeds required return 15%
  4. DFairly priced, since 16% lies between the risk-free rate and the market return

Explanation

Required return = 7 + 1.25×(15−7) = 7 + 10 = 17%. Expected return of 16% is less than 17%, so the share plots below the security market line and is overvalued. Option A has a false comparison (16 does not exceed 17).

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