Answer to Question #145885 in Financial Math for Eric

Question #145885
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.
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Expert's answer
2020-11-22T17:05:15-0500

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.





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