Answer to Question #145885 in Financial Math for Eric

Question

b) An investor anticipates Newco’s Security will reach $30 by the end of year. Newco’s beta is 1.3. Assume the return on the market is expected to be 16% and risk free rate is 4%. Calculate the expected return of Newco’s share in one year and determine whether the share is undervalued, overvalued or properly valued with a current value of $25.
c) Differentiate between non-diversifiable risk and liquidity risk.
d) As a trustee of a bond holders, provide two covenants you will insist to be stated in the bond contract. Give reasons for your answer.

Answer 1

b) $E(R)_{Newco} = 4\% +1.3(16\%-4\%)=20\%$

given the expected return of Newco's stock using CAPM is 20$\%$ and the investor anticipate a 20$\%$ return, the security will be properly valued.

• if the expected return using the CAPM is higher than the investor's required return, the security is undervalued.
• if the expected return using the CAPM is lower than the investor's required return,the security is overvalued.

(c). non - diversifiable risk is an investment risk that cannot be mitigated by diversification of an asset portfolio while liquidity risk is a financial risk that for a certain period of time a given financial asset, security,or commodity cannot be traded quickly enough in the market without impacting the market price.

[d] Types of covenant to be stated in the bond contract;

• provide yearly audited financial statements.
• Achieve a certain threshold in certain financial ratios.