10. The Capital Asset Pricing Model and the security market line Keith holds a p

Question

10. The Capital Asset Pricing Model and the security market line Keith holds a portfolio that is invested equally in three stocks (WDWA- W 1/3). Each stock is described in the following table: Stock Beta Standard Deviation Expected Return DET 0.7 AIL 1.0 INO 1.6 25% 38% 34% 8.0% 10.0% 13.5% An analyst has used market- and firm-specific information to make expected return estimates for each stock. The analyst's expected return estimates may or may not equal the stocks' required returns. The risk-free rate [Rr] is 6%, and the market risk premium [RPMj is 4%. Use the following graph with the security market line (SML) to plot each stock's beta and expected return. Tool tip: Mouse over the points on the graph to see their coordinates.

Explanation / Answer

Working Note:

Step 1: Calculation of Required Return using Capital Asset Pricing Model

Required Return = Rf + b ( Rm – Rf )

Where,

Rf – Risk free return

b – Beta

Rm – Expected return on market portfolio

Required Return for Stock DET = 6 + .7* 4

= 6 + 2.8

= 8.80%

Required Return for Stock AIL = 6 + 1* 4

= 6 + 4

= 10.00%

Required Return for Stock INO = 6 + 1.6* 4

= 6 + 6.4

= 12.40%

Require Return Expected Return Valuation Stock DET 8.00% 8.80% Under Valued Stock AIL 10.00% 10.00% Fairly Valued Stock INO 13.50% 12.40% Over Valued

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