Question

You are trying to decide whether to purchase stock or not. The stock is currently sold for $41.54 and is expected to be $45.33 in a year. A dividend of $2.00 per share will be distributed during the year. The stock has a beta of 1.1. The risk-free rate is 3%, and the expected return on the market is 12%. Based on the information, should you buy the stock?

No, because the expected return of the stock is above the SML.

Yes, because the expected return of the stock is below the SML.

Yes, because the expected return of the stock is above the SML.

No, because the expected return of the stock is below the SML.

Answer 1

Given that,

risk free rate Rf = 3%

Market expected return Rm = 12%

Beta of the stock = 1.1

So, using CAPM, expected return of the stock Ke = Rf + Beta*(Rm-Rf)

So, Ke = 3 + 1.1*(12-3) = 12.9%

The stock is currently sold for $41.54 and is expected to be $45.33 in a year. A dividend of $2.00 per share

Current stock price P0 = $41.54

Expected price after 1 year P1 = $45.33

Dividend this year D = $2

So, expected return based on the price is (P1 - P0 + D)/P0 = (45.33 - 41.54 + 2)/41.54 = 13.94%

Since this return is greater than expected return based on CAPM model, stock should be bought.

So, option C Yes, because the expected return of the stock is above the SML is correct.