Stock Y has a beta of 1.30 and an expected return of 14.6 percent. Stock Z has a

Question

Stock Y has a beta of 1.30 and an expected return of 14.6 percent. Stock Z has a beta of 0.75 and an expected return of 11.3 percent.

If the risk-free rate is 5.00 percent and the market risk premium is 7.50 percent, are these stocks correctly priced? in other words is stock Y undervalued, overvalued, or correctly price, is stock X undervalued, overvalued ,or correctly priced?

Stock Y has a beta of 1.30 and an expected return of 14.6 percent. Stock Z has a beta of 0.75 and an expected return of 11.3 percent.

Explanation / Answer

Solution Y Z Beta 1.3 0.75 Expected return 14.60% 11.30% Rf = 5% Rm - Rf = 7.50% calculation based on CAPM [Y] Ke = Rf + [(Rm - Rf) * b] = 5% + [7.5% * 1.3] = 14.75% Given Return is 14.60% so Y is overvalued. [Z] ke = 5% + [7.5% * 0.75] = 10.625% Given Return is 11.30%% so Z is undervalued.

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