allen_wml

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allen_wml

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bingning

59、An analyst gathered the following information about two common stocks:

	Easy Company	Bravo Enterprises
Estimated future rate of return	12.0%	11.5%
Beta	1.25	1.00

If the risk-free rate of return is 5 percent and the market risk premium is 6 percent, the most appropriate conclusions about the value of the common stocks of Easy Company and Bravo Enterprises, respectively, are:

	Easy Company common stock	Bravo Enterprises common stock
A.	Overvalued	Overvalued
B.	Overvalued	Undervalued
C.	Undervalued	Overvalued
D.	Undervalued	Undervalued

A. Answer A

B. Answer B

C. Answer C

D. Answer D

 Correct answer = B

"An Introduction to Asset Pricing Models," Frank K. Reilly and Keith C. Brown
2008 Modular Level I, Vol. 4, pp. 263-267
Study Session 12-51-e
calculate, using the SML, the expected return on a security, and evaluate whether the security is overvalued, undervalued, or properly valued
The required rate of return for Easy is 5% + 1.25(6%) = 12.5%. The required return is greater than the estimated return, so the stock is overvalued. Bravo's required rate of return is 5% + 1(6%) = 11% (because the beta is 1.0, the return is the same as the market). The required return is less than the estimated return, so the stock is undervalued.