You expect the risk-free rate (RFR) to be 5 percent and the market return to be 9 percent. You also have the following information about three stocks….

You expect the risk-free rate (RFR) to be 5 percent and the market return to be 9 percent. You also have the following information about three stocks.  

                           CURRENT    EXPECTED   EXPECTED

       STOCK    BETA      PRICE        PRICE           DIVIDEND

         X      1.50      $ 22         $ 23          $ 0.75

         Y      0.50      $ 40        $ 43          $ 1.50

         Z      2.00      $ 45         $ 49          $ 1.00

Required:

(a) Calculate the expected rate of return for each stock.

(b) Calculate the required rate of return (using the CAPM) for each stock.

(c) Identify, which stocks are underpriced, overpriced or correctly priced.

(d) Illustrate your answer with a graph showing the Security Market Line and the positions of the three stocks.

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