Question

Which one of the following stocks is correctly priced if the risk-free rate of return is 2.4 percent and the market risk premium is 7.80 percent? Stock Beta Expected Return A 0.72 8.43% B 1.48 14.00% C 1.40 13.32% D 1.06 10.58%

Answer 1

Answer:

Stock C

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

The (Market rate of return - Risk-free rate of return)  is also called market risk premium

For Stock A

= 2.4% + 0.72 × 7.80%

= 2.4% + 5.616%

= 8.016%

For Stock B

= 2.4% + 1,48 × 7.80%

= 2.4% + 11.544%

= 13.944%

For Stock C

= 2.4% + 1.40 × 7.80%

= 2.4% + 10.92%

= 13.32%

For Stock D

= 2.4% + 1.06 × 7.80%

= 2.4% + 8.268%

= 10.668%

Since we see that the expected rate of return for stock C is equal to the expected rate of return so the stock C is correctly priced