Here are data on two companies. The T-B ill rate is 4% and the market risk premi

Question

Here are data on two companies. The T-Bill rate is 4% and the market risk premium is 6%

Company Store A Store B

Forescasted return 12% 11%

Standard deviation of returns 8% 10%

Beta 1.5 1.0

a. Estimate the expected return for each company according to CAPM

b. Characterize each company as underpriced, overpriced, or properly priced according to CAPM

c. Another company, store C, has a beta of 2.0. Assuming efficient market hypothesis (CAPM holds), estimate the expected rate of return for a portfolio consisting of 1/3 stock A, 1/3 stock B, and 1/3 store C

Explanation / Answer

a. Estimate the expected return for each company according to CAPM

StoreA = 4+6*1.5 = 13%

StoreB = 4+6*1 = 10%

b. Characterize each company as underpriced, overpriced, or properly priced according to CAPM

StoreA Alpha=12-13 = -1 i.e Overpriced

StoreB Alpha=11-10 = 1 i.e Underprice

c. Another company, store C, has a beta of 2.0. Assuming efficient market hypothesis (CAPM holds), estimate the expected rate of return for a portfolio consisting of 1/3 stock A, 1/3 stock B, and 1/3 store C

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