21. Suppose the rate of return on short-term government securities (perceived to

Question

21. Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model: a. What is the expected rate of return on the market portfolio? What would be the expected rate of return on a stock with = 0? c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 divi dends next year and you expect it to sell then for $41. The stock risk has been evaluated a =-5. Is the stock overpriced or underpriced?

Explanation / Answer

a)Expected rate of return =RF+[beta*(Rm-Rf)]

     = 5+[1*(12-5)]

        = 5+ [1*7]

           = 5+7

           = 12%

b)Expected rate of return = 5+ [0**12-5)]

          = 5+ [0*7]

            = 5+0

            = 5 %

c)Required rate of return = 5+[-.5*(12-5)]

         = 5+ [-.5* 7]

       = 5- 3.5

      = 1.5%

expected return = [P1-P0+D]/P0

        =[41-40+3]/40

          = 4/40

           = .10 or 10%

since the expected return is more than required return(1.5%] ,stock is underpriced .

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