Directions: You MUST show ALL of your work to receive credit on the problems. There will be significant point reductions if you do not show your work. All calculations should be completed to at least 2 decimal places.
1) You are considering acquiring a firm that you believe can generate expected cash flows of $10,000 a year forever. However, you recognize that those cash flows are uncertain.
A) Suppose you believe that the beta of the firm is 0.4. How much is the firm worth if the risk-free rate is 4% and the expected rate of return on the market portfolio is 11%?
B) By how much will you overvalue the firm if its beta is actually 0.6?
2) If the risk- free rate is 6% and the expected rate of return on the market portfolio is 13%, is a security with a beta of 1.25 and an expected rate of return of 16% overpriced or underpriced?