Question

The common stock of Alpha Manufacturers has a beta of 1.14 and an actual expected return of 15.26 percent. The risk-free rate of return is 4.3 percent and the market rate of return is 12.01 percent. Which one of the following statements is true given this information? To be correctly priced according to CAPM, the stock should have an expected return of 21.95 percent.
a. The actual expected return will graph below the Security Market Line.
b. The stock has less systematic risk than the overall market.
c. The stock is overpriced.
d. The actual expected stock return indicates the stock is currently underpriced.

Answer 1

Answer: d. The actual expected stock return indicates the stock is currently underpriced.

Explanation:

According to CAPM, the expected return is:

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

= 4.3% + 1.14 * (12.01% - 4.3%)

= 13.09%

The actual expected return is greater than the CAPM expected return.

This stock is underpriced because it is bringing in a higher return than CAPM predicted based on the market.