At present, the risk-free rate is 5% and the expected return on the market portf

Question

At present, the risk-free rate is 5% and the expected return on the market portfolio is 11%. The expected returns for four stocks are given below. On the basis of these expectations, which stock(s) is(are) overvalued and which undervalued? Why?

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               Stock                          Expected Return             Expected Beta

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      1.      Dong Peng                           .200                                     1.2

      2.      Hua Wei                              .125                                     1.4

      3.      Bei Nan                               .100                                     0.8

      4.      Dong Xi                               .116                                     1.1

Explanation / Answer

Required Return of as per Capital Asset Pricing Model:

1. Dong Peng stock=0.05+(0.11-0.05) (1.2)=0.122

which is less than expected return od Dong Peng i.e. 0.200,Hence the stock is undervalued.

2. Similarly, Hua Wei stock= 0.05+(0.06) (1.4)=0.134,which is greater than expected return i.e.0.125, So, Stock is overvalued.

3.BEI Nan Stock=0.05+(0.06) (0.8)=0.098, which is less than expectedreturn i.e.0.100, So, Stock is undervalued.

4.Dong xi Stock =0.05+(0.06) (1.1)=0.116, which is equal to expected return i.e.0.116, So,at this stock is just at equillibrium.

regards

Bhanu

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