Question

The common stock of Alpha Manufacturers has a beta of 1.18 and an actual expected return of 13.33 percent. The risk-free rate of return is 3.3 percent and the market rate of return is 12.20 percent. Which one of the following statements is true given this information?
A. The stock has less systematic risk than the overall market.
B. To be correctly priced according to CAPM, the stock should have an expected return of 13.56 percent.
C. The actual expected stock return will graph above the security market line; thus the stock is underpriced.
D. The actual expected stock return indicates the stock is currently overpriced.

Answer 1

Answer:

D. The actual expected stock return indicates the stock is currently overpriced.

Explanation:

The actual rate of return of this stock = 13.33%

Rate of return using CAPM:

r = risk free rate + beta(Market return- risk free rate)

risk free = 3.3% or 0.033 as a decimal

beta = 1.18

market return = 12.20% or 0.1220 as a decimal

r = 0.033 + 1.18(0.1220 - 0.033)

= 0.033 + 0.10502

= 0.1380 or 13.80%

Since rate of return and price of a stock have inverse relationship, the actual rate of return is lower meaning that the stock is currently overpriced.