1. The risk-free rate is 3%, the expected market rate of return is 9%, if you ex

Question

1. The risk-free rate is 3%, the expected market rate of return is 9%, if you expect a stock with a beta of 1.5 to offer a rate of return of 12%, you should

a) buy the stock because it is overpriced

b) sell short the stock because it is overpriced

c) sell short the stock because it is underpriced

d) buy the stock because it is underpriced

e) none of the above as the stock is fairly priced

2. You are considering acquiring a common stock that you'd like to hold for one year. You expect to receive both $1.50 in dividends and $42 from the sale of the stock at the end of the year. The maximum price you would pay for the stock today if you wanted to earn a 10% return is closest to

a) $38.50

b) $39.15

c) $39.55

d) $47.85

Explanation / Answer

CAPM Return = 3% + 1.5 ( 9% -3%) = 9%

If the CAPM return (9%) is less than required return ( 12%) then the security is overpriced and should be sold

Hence the correct choice is C

Return = (Dividend + Sale Price - Purchase Price ) / Purchase price = 10%

1.5 + 42 = 1.1 * Purchase Price

Or Purchase Price = 43.50 / 1.1 = 39.55

Correct Choice: C

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