Suppose the yield on short-term government securities (perceived to be risk-free

Question

Suppose the yield on short-term government securities (perceived to be risk-free) is about 4%. Suppose also that the expected return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model:

a) What is the expected return on the market portfolio?

b) What would be the expected return on a zero-beta stock?

c) Suppose you consider buying a share of stock at a price of $40. The stock is expected to pay a dividend of $3 next year and to sell then for $41. The stock risk has been evaluated at =-.5. Is the stock overpriced or underpriced?

Explanation / Answer

expected return = risk free rate + beta * (market return - risk free rate)

a)

expected return = 4% + 1 * (12%-4%)

= 12%

b)

expected return = 4% + 0 * (12% -4%)

= 4%

c)

expected return = 4% + (-0.5) * (12%-4%)

= 0

Actual return = D1/Po + (P1-P0)/P0

= 3/40 + 41-40/40

= 0.1

= 10%

The stock is underpriced as the return per CAPM is less compared to return as per dividiend growth model

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