You expect the risk-free rate (RFR) to be 5 percent and the market return to be

Question

You expect the risk-free rate (RFR) to be 5 percent and the market return to be 9 percent. You also have the following information about three stocks.  

                                                      CURRENT           EXPECTED    EXPECTED

       STOCK                   BETA       PRICE             PRICE            DIVIDEND

         X                     1.50          $ 22               $ 23              $ 0.75

         Y                     0.50          $ 40                $ 43              $ 1.50

         Z                      2.00          $ 45              $ 49              $ 1.00

Required:

a.Calculate the expected rate of return for each stock.

b.Calculate the required rate of return (using the CAPM) for each stock.   

c.Identify, which stocks are underpriced, overpriced or correctly priced.   

d.Illustrate your answer with a graph showing the Security Market Line and the positions of the three stocks.

Explanation / Answer

a) Calculate the expected rate of return for each stock Estimated Expected Rate of return = (Expected Price - Current Price + Expected Dividend)/Current price Stock X (23-22+0.75)/22*100 7.95% Stock Y (43-40+1.5)/40*100 11.25% Stock Z (49-45+1)/45*100 11.11% b) Required rate of return for each stock Stock X Stock Y Stock Z Required return = Risk free rate+ Beta(Market rate-risk free rate) 5%+1.5(9%-5%) 5%+0.5(9%-5%) 5%+2(9%-5%) 5%+1.5(4%) 5%+0.5(4) 5%+2(4) 11% 7% 13% c) Stock X Expected return is less than required rate of return, therefore share price is overvalued Stock Y Expected return is more than required rate of return, therefore share price is undervalued Stock Z Expected return is less than required rate of return, therefore share price is overvalued

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