Question

The risk-free rate is 7% and the market risk premium (Rm-Rf) is 8%. The following additional information is available for Stocks A and B.

                                                                          Stock A                                  Stock B

                Beta                                                                       1.20                                        0.80

                Expected dividend next year                             $1.00                                      $1.75

                Growth rate (g)                                                     7%                                          4%

                Current Price (p₀)                                                $20                                         $35

a.             What are the required and expected rates of returns of both stocks? Which stock would you recommend to purchase and which to sell? Explain.

Answer 1

As per CAPM : Required Return

Required Return = Rf + beta (Rm - Rf)

Stock A = Rf + beta (Rm - Rf)

= 7% + 1.2 (8%)

= 16.6%

Stock A = Rf + beta (Rm - Rf)

= 7% + 0.8 (8%)

= 13.4%

Expected Return

Value of Stock =

Value of Stock A =

20 =

20 * Rate of Retrun - 0.07 * 20 = 1

20 * Rate of Retrun - 1.4 = 1

Rate of Retrun = 1 + 1.4 / 20

Rate of Retrun = 12%

Value of Stock B =

35 =

35 * Rate of Retrun - 0.04 * 35 = 1.75

35 * Rate of Retrun - 1.4 = 1.75

Rate of Retrun = 1.75 + 1.4 / 35

Rate of Retrun = 9%

CAPM of both the stocks are more than the expected return, which means that the both the stocks are overvalued. Both the stocks should be sold.