Question

A friend has some reliable information that the stock of Puddles Company is going to rise from $43.00 to $50.00 per share over the next year representing an annual return of 16.28%. You know that the annual return on the S&P 500 has been 11% and the 90-day T-bill rate has been yielding 5% per year over the past 10 years. If beta for Puddles is 1.5, will you purchase the stock?

Question 16 options:

	1) Yes, because it is overvalued.
	2) Yes, because it is undervalued.
	3) No, because it is undervalued.
	4) No, because it is overvalued.

Answer 1

As per CAPM =

= R: + betal Rn - Ri)

= 5% + 1.5 ( 11% - 5%)

= 14%

Required Rate of Return is 14% while Expected Return is 16.28%.

Required Rate of Return <  Expected Return, Therefore Stock is undervalued we always buy undervalued stock.

Option 2) is correct. Yes, because it is undervalued.

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