Question

Start from a position of financial market equilibrium for the price of a company’s stock. Evaluate the impact of the cited event on this initial equilibrium and determine the predicted impact on the intrinsic value and, in equilibrium, the actual stock price.

I. the expected rate of return is now higher than the required rate of return; or, equivalently, the required rate of return is now lower than the expected rate of return 

II. the expected rate of return is now lower than the required rate of return; or, equivalently, the required rate of return is now higher than the expected rate of return 

A. the company’s stock price should increase to restore equilibrium

B. the company’s stock price should decrease to restore equilibrium

(39) Both an improvement in investor confidence impacting the market risk premium

         accompanied by an improvement in a company’s current earnings

   (a) I and A                    (c) II and A

   (b) I and B                    (d) II and B

Answer 1

Answer is (a) and (d) option

Example: An investor anticipates X security will reach $30 by the end of one year. X beta is 1.3. Assume the return on the market is expected to be 16% and the risk-free rate is 4%. Calculate the expected return of X stock in one year and determine whether the stock is undervalued, overvalued or properly valued with a current value of $25.

Answer: Solving it using CAPM model

E(R)of X = 4% + 1.3(16% - 4%) = 20%

Given the expected return of X stock using CAPM is 20% and the investor anticipates a 20% return, the security would be properly valued.

Now,

1. If the expected return using the CAPM is higher than the investor's required return, the security is undervalued and the investor should buy it.

2. If the expected return using the CAPM is lower than the investor's required return, the security is overvalued and should be sold