Question

26. Two stocks, one high risk (Happy) and one low risk (Lonely), have been evaluated by your company. Your stock analysis team has predicted estimated returns and beta risk in the table below for the two stocks and the market. Using this information, and the CAPM model, draw the risk-return graph, with the security market line, and place the estimate return and the CAPM required rate of return on the graph and indicate to me if Happy and Lonely are over-valued or under-valued and WHY. Provide your answer in the uploaded document.

Est(R)             Beta                

            Market             .26                   1.00                

            Happy             .33                   1.20                

            Lonely             .14                   0.75

            The risk-free rate is 3%

Answer 1

Using CAPM, required rate can be calculated as Rf+Beta*(Rm-Rf); where Rf is risk free rate, Rm is market return and Rm-Rf is market risk premium.

Required rate of return of Happy= 3%+1.2*(26%-3%)= 30.6%

Required rate of Lonely= 3%+0.75*(26%-3%)= 20.25%

Drawing Security Market Line with the above information:

From the Security Market Line graph, Lonely is over valued, as it is below Security Market Line and Happy is under valued as it is above Security Market Line.