You are given the following information for company \"XYZ Corp\" and the financi

Question

You are given the following information for company "XYZ Corp" and the financial markets.

• ß of stock X = 1.4
• recent dividend = $2.00
• constant growth rate = 8%
• projected stock market return = 14%
• yield on a 10-year treasury = rRF = 6.46%

• Calculated Stock Price = $23.957409 (23.96 rounded)

Question: Referring to the CAPM rate of return used to calculate the above Stock Price, suppose the actual rate of return according to the market is 18.60%. According to CAPM, is the stock undervalued or overvalued? Explain.

Explanation / Answer

Using CPAM formula we get return on stock as:

0.046+1.4*(0.14-0.046)=17.76%

and actual return is 18.60%

It is undervalued, because investors expect a higher return (18.6%) given the same amount of systematic risk.

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