Question

vi. You have been scouring The Wall Street Journal looking for stocks that are good values" and have calculated expected returns for five stocks. Assume the risk-free rate (krp) is 7 percent and the market risk premium (km - krp) is 2 percent. Which security would be the best investment? (Assume you must choose just one.) Expected Return Beta a. 9.01% 1.70 b. 7.06% 0.00 c. 5.04% -0.67 d. 8.74% 0.87 e. 11.50% 2.50

Answer 1

Part 1:

Concept:

Capital Asset pricing model:

As per CAPM model:
Re= Rf+(Rm-Rf)B

Re= required rate of return.
Rf= Risk-free rate.
Rm = Return on market.
Rm-Rf =Market Risk Premium.
B = Beta, systematic risk.

Concept:
If the expected rate of return is more than the required rate of return than the stock will create value for its shareholder, as the stock return is more than the shareholders required expectation.

Expected> Required = Underpriced

Otherwise overpriced.  

Expected- Required = higher the better.

Part 2:
a. Required Re= 7+2x1.70 = 10.4%

Expected= 9.01%

Expected- Required = -1.39%

b. Required Re= 7+2x0 = 7%

Expected= 7.06%

Expected- Required = 0.06%

c. Required Re= 7+2x(-0.67) = 5.66%

Expected= 5.04%

Expected- Required = -0.62%

d. Required Re= 7+2x0.87 = 8.74%

Expected= 8.74%

Expected- Required = 0%

e. Required Re= 7+2x2.50 = 12%

Expected= 11.50%

Expected- Required = -0.5%

Conclusion: option B is better with an expected return of 7.06%.