The risk free rate is 5% and the market return is 14% p.a. The standard deviation or the market return is 13%.
a) Evaluate whether or not the share price of MK Ltd is overvalued or undervalued.
b) Discuss why your results in (a) above might not correctly identify whether or not the share price of MK Ltd is undervalued or overvalued.
a) Compute the beta of each of the four projects.
Compute the overall portfolio Beta
Using CAPM, return of a portfolio (Rp) = 5% + (14% – 5%)0.8605 = 12.75 Compute the expected % portfolio return
(Erp) from historical returns
(0.28 x 10%) + (0.17 x 18%) + (0.31 x 15%) + (0.24 x 13%) = 13.63%
Rp = 12.75%
Erp = 13.63% Undervalued shares
b) Reasons why the results may not correctly identify whether the share price is over or undervalued.
Use of historical data on returns, risk and correlation The market is not fully efficient as assumed CAPM
Market risk premium (Rm-Rf) is not constant since Rm & Rf will vary overtime Restrictive assumptions of CAPM
CAPM is a single factor model CAPM i s a single period model.