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Answer: overvalued | 13.8%
## Explanation **Step 1: Calculate the forecasted beta** \[ \text{Forecasted beta} = 0.80 + 0.20 \times \text{historical beta} \] \[ \text{Forecasted beta} = 0.80 + 0.20 \times 1.50 = 0.80 + 0.30 = 1.10 \] **Step 2: Calculate the CAPM required return** \[ \text{Required return} = \text{Risk-free rate} + \text{Forecasted beta} \times \text{Market risk premium} \] \[ \text{Required return} = 5\% + 1.10 \times 8\% = 5\% + 8.8\% = 13.8\% \] **Step 3: Compare predicted return with required return** - Predicted return (Franklin's forecast): 10% - Required return (CAPM): 13.8% Since the predicted return (10%) is **less than** the required return (13.8%), the stock is **overvalued**. **Valuation Decision**: Overvalued with CAPM required return of 13.8% **Correct Answer**: B (overvalued | 13.8%)
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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):
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):
A
overvalued | 8.3%
B
overvalued | 13.8%
C
undervalued | 8.3%
D
undervalued | 13.8%
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