Question

Q3) Recently your broker has advised you that he believes that the stock of Casey Incorporated is going to rise from £55.00 to £70.00 per share over the next year. You know that the annual return on the S&P 500 has been 12.5% and the 90-day T-bill rate has been yielding 6% per year over the past 10 years. If beta for Casey is 1.3, will you purchase the stock?

a. Yes, because it is overvalued.

b. Yes, because it is undervalued.

c. No, because it is undervalued.

d. No, because it is overvalued.

e. Yes, because the expected return equals the estimated return.

** SHOW YOUR WORKINGS

Answer 1

Answer: Option b is correct

Expected return=(70-55)/55=27.27%

Required return=Risk free rate +Beta*(Market return-Risk free rate)

Required return=6% +1.3*(12.5%-6%)
=6% +8.45%
=14.45%

As the expected return is more than the required return, the stock is undervalued.