Question

Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 8%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 16%. According to the capital asset pricing model: a. What is the expected rate of return on the market portfolio? (Round your answer to 2 decimal places.) Expected rate of return b. What would be the expected rate of return on a stock with B = 0? (Round your answer to 2 decimal places.) Expected rate of return c. Suppose you consider buying a share of stock at $57. The stock is expected to pay 53.5 dividends next year and you expect to sell then for $60. The stock risk has been evaluated at = -5. Is the stock overpriced or underpriced?

Answer 1

required rate of return= Rf + (Beta * (Rm - Rf))

16% = 8% +(1 * (Rm - 8%))

16% = 8% + Rm - 8%

Rm = 16%

Expected rate of return on market portfolio = 16%

* When the stock has beta equal to one the market return and stock return are same

required rate of return= Rf + (Beta * (Rm - Rf))

Required rate of return = 8% +(0 * (16% - 8%))

Expected rate of return = 8%

* When the stock has beta equal to zero the expected return is same as risk free rate

required rate of return= Rf + (Beta * (Rm - Rf))

Required rate of return = 8% +(-0.5 * (16% - 8%))

Required rate of return = 4.0%

Present value of stock = (60 + 3.50)/(1+4%)

Present value of stock = 61.06

As present value of stock is 61.06 which is greater than current price stock is underprized