Question

The market risk premium is 11.40 percent; the risk free rate of return is 3.80 percent and the Capital Asset Pricing Model is valid. A stock has a beta of 1.69 and an analyst has estimated that the expected return of the stock is 20.40 percent. Given the information above, the stock is ________________________.

Answer 1

According to CAPM model

Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

Where (Market Return – Risk-Free Rate)= Market risk premium

expected return= .038+1.69*(.114)

=23.06%

Expected return by analyst = 20.40%

Since the ecpected return by CAPM> analysts expected return ,this means at the level of risk being taken by analyst the return should have been earning at least the return given by CAPM i.e 23.06 % but the analyst expects 20.4% return only.Thus the stock is overpriced/overvalued