Question

Stock A has a beta of .92 and an expected return of 9.04 percent. Stock B has a beta of 1.04 and an expected return of 9.51 percent. Stock C has a beta of 1.36 and an expected return of 11.68 percent. The risk-free rate is 3 percent and the market risk premium is 6.5 percent. Which of these stocks are underpriced?

Answer 1

Answer:

Stock A

Explanation:

We will calculate the Capital Assets Pricing Model or each stock and look for one underpriced

All shares face the same market premium and risk-free rate:

$Ke= r_f + \beta (r_m-r_f)$  

risk free rate=0.03

premium market = (market rate - risk free)= 0.065

Stock A

beta(non diversifiable risk) 0.92

$Ke= 0.03 + 0.92 (0.065)$  

Ke 0.08980= 8.98% expected return 9.04%

The CAPM cost of capital is lower than his expected return, therefore, for CAPM this stock is underprices as the expected return is greater than his cost of capital.

Stock B

beta(non diversifiable risk) 1.04

$Ke= 0.03 + 1.04 (0.065)$  

Ke 0.09760= 9.76%    expected return 9.51%

The CAPM cost of capital is greater than his expected return, therefore, for CAPM this stock is overpriced as the expected return is lower than his cost of capital

Stock C

beta(non diversifiable risk) 1.36

$Ke= 0.03 + 1.36 (0.065)$

Ke 0.11840= 11.84%     expected return 11.68%

The CAPM cost of capital is greater than his expected return, therefore, for CAPM this stock is overpriced as the expected return is lower than his cost of capital