You are given the following information about Wendy\'s International and Sbarro

Question

You are given the following information about Wendy's International and Sbarro (pizza and restaurants).

            Stock              Current          Expected            Expected         Estimated

                                    Price               Price                  Dividends          Beta

            Wendy's         $28.875         $32.625                     $1.25              1.05

            Sbarro            $51.25           $55.875                     $0.60              1.25

                                    ERM = .14   RF = .07   

            a) Estimate the expected returns using the CAPM.

            b) Calculate the predicted returns for each stock.

            c) Determine which stock is overvalued or/and undervalued.

                 Explain.

            d) Explain where the predicted returns would plot (above or below) the SML. Explain.

Explanation / Answer

a. Wendy's = 7 + 1.05*7 = 14.35%

Sbarro = 7 + 1.25*7 = 15.75%

b. Wendy's = 32.625+1.25/28.875 - 1 = 17.32%

Sbarro = 55.875+0.6/51.25 - 1 = 10.20%

c. Wendy's is undervalued since the price is lesser thereby creating more predictedreturn

Sbarro is overvalued since the predicted return in lesser than the expected return

d. Wendy's would be above the SML while Sbarro would be below it

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