Question

Assume you observe the following situation:

Security                       Beta    Expected Return

A                                  1.2                   13%

B                                  0.6                   10%

The Treasury Bill rate is 5 per cent. Which one of the two securities are overvalued relative to the other? Show your workings.

(2 Marks)

Answer 1

Answer to the question:
RF + Risk premium * Beta(A) i.e. 1.2 = 13%......... equation 1
RF + Risk Premium * Beta(B) i.e. 0.6 = 10%........ equation 2
Now on substract 2 from 1, we get
0.6 beta * risk premium = 3%
Hence risk premium = 5%

Now put this risk premium in equation to CAPM of security A to calculate cost of equity
- Risk Free Rate + (Market Risk Premium * Beta)
5% + (5 * 1.20)
=11%

Now put this risk premium in equation to CAPM of security B to calculate cost of equity
- Risk Free Rate + (Market Risk Premium * Beta)
5% + (5 * 0.6)
= 8%

From the above we get that Expected return of both the securities is higher than there cost,
Hence both the securities are overvlued.