Question

You are analyzing a stock that has a beta of 1.28. The risk-free rate is 3.7% and you estimate the market risk premium to be 7.6%. If you expect the stock to have a return of 12.5% over the next year, should you buy it? Why or why not? The expected return according to the CAPM is %. (Round to two decimal places.) Should you buy the stock? (Select the best choice below.) O A. No, because the expected return based on the beta is greater than the return on the stock. B. Yes, because the expected return based on the beta is equal to or less than the return on the sto O

Answer 1

a)Expected return as per CAPM :Risk free rate+ [Beta* market risk premium]

                                   = 3.7 + [1.28 *7.6]

                                   = 3.7 + 9.73

                                   = 13.43%

B)If expected return of security is less than required return as per CAPM ,security is overvalued and you must take a short position.

In a given can since expected return of 12.5% is less than required return as per CAPM 13.43% ,therefore the stock is overvalued and you should not buy the stock..

correct option is "A" -No