Question

Your sister-in-law, a newly minted graduate just landed her first job with a large research firm. Her first assignment was to come up with an estimate of the change in share price for Bubbly Incorporated over the next twelve months. She estimates the price will rise from $50 to $70 per share over the next year and highly recommends you place a buy order.  

You recall from your Corporate Finance course that the estimated return and risk are the only parameters that should be considered in the investment decision & have decided to us the CAPM to help you access the desirability of purchasing shares in this firm.  

Assuming an expected return on the market over the next 12 months of 10%, a risk free rate of 5%, a beta for Bubbly of 1.00 please answer the following questions:

Briefly define the CAPM and explain its use in the investment analysis process

Based on the CAPM what is the required return on an investment in Bubbly over the next 12 months? Would you make the purchase (why or why not)?

What would you expect to happen to the stock price of Bubbly in the short term? Why?

Answer 1

CAPM is used to find the required return for a stock given its sytematic risk
One can use required return from CAPM to decide whether the stock should be purchased or not
If required return is less than expected return then it means the stock is undervalued and one should buy the stock
If required return is more than expected return then it means the stock is overrvalued and one should sell the stock
required return=risk free+beta*market risk premium=5%+1*(12%-5%)=12%
expected return=70/50-1=40%
As expected return is more than required return, she should make the purchase becuase it is currently undervalued
Investors would flock to buy this stock as it is undervalued and hence price would rise and expected return would come down