clearlycanadian

What is the expected rate of return on a stock that has a beta of 1.4 if the market risk premium is 9% and the risk-free rate is 4%?

A) 13.0%.

B) 16.6%.

C) 11.0%.

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Using the security market line (SML) equation:
4% + 1.4(9%) = 16.6%.

clearlycanadian

If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock?

A) 7.8%.

B) 11.3%.

C) 12.4%.

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The formula for the required return is: ERstock = Rf + (ERM – Rf) × Betastock,
or 0.035 + (0.095 – 0.035) × 1.3 = 0.113, or 11.3%.

clearlycanadian

Given a beta of 1.25 and a risk-free rate of 6%, what is the expected rate of return assuming a 12% market return?

A) 10%.

B) 31%.

C) 13.5%.

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k = 6 + 1.25 (12 − 6)
= 6 + 1.25(6)
= 6 + 7.5
= 13.5

clearlycanadian

Given the following information, what is the required rate of return on Bin Co?

• inflation premium = 3%
• real risk-free rate = 2%
• Bin Co. beta = 1.3
• market risk premium = 4%

A) 7.6%.

B) 16.7%.

C) 10.2%.

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Use the capital asset pricing model (CAPM) to find the required rate of return. The approximate risk-free rate of interest is 5% (2% real risk-free rate + 3% inflation premium).

k = 5% + 1.3(4%) = 10.2%.

clearlycanadian

Given a beta of 1.55 and a risk-ree rate of 8%, what is the expected rate of return, assuming a 14% market return?

A) 12.4%.

B) 17.3%.

C) 20.4%.

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k = 8 + 1.55(14-8)
= 8 + 1.55(6)
= 8 + 9.3
= 17.3

clearlycanadian

The following information is available for the stock of Park Street Holdings:

• The price today (P0) equals $45.00.
• The expected price in one year (P1) is $55.00.
• The stock's beta is 2.31.
• The firm typically pays no dividend.
• The 3-month Treasury bill is yielding 4.25%.
• The historical average S&P 500 return is 12.5%.

Park Street Holdings stock is:

A) overvalued by 1.1%.

B) undervalued by 3.7%.

C) undervalued by 1.1%.

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To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).
Step 1: Calculate Expected Return (Holding period return):
The formula for the (one-year) holding period return is:

HPR = (D1 + S1 – S0) / S0, where D = dividend and S = stock price.

Here, HPR = (0 + 55 – 45) / 45 = 22.2%

Step 2: Calculate Required Return:
The formula for the required return is from the CAPM:

RR = Rf + (ERM – Rf) × Beta
RR = 4.25% + (12.5 – 4.25%) × 2.31 = 23.3%.

Step 3: Determine over/under valuation:

The required return is greater than the expected return, so the security is overvalued.
The amount = 23.3% − 22.2% = 1.1%.

clearlycanadian

A stock that plots below the Security Market Line most likely:

A) has a beta less than one.

B) is overvalued.

C) is below the efficient frontier.

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Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or underpriced graphically or mathematically.  Your answers will always be the same.
Graphically: If you plot a stock’s expected return on the SML and it falls below the line, it indicates that the stock is currently overpriced, causing its expected return to be too low.  If the plot is above the line, it indicates that the stock is underpriced.  If the plot falls on the SML, it indicates the stock is properly priced.
Mathematically: In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

clearlycanadian

Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.Snow places:

A) only Cubb on the list.

B) neither security on the list.

C) only Bahre on the list.

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In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free rate).

• For Bahre: ER =  10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not put on buy list.
• For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do not put on buy list (per Snow's manager).

clearlycanadian

Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.Snow places:

A) only Cubb on the list.

B) neither security on the list.

C) only Bahre on the list.

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In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free rate).

• For Bahre: ER =  10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not put on buy list.
• For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do not put on buy list (per Snow's manager).

clearlycanadian

An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how much (expressed as percentage return). The analyst gathers the following information on the stock:

• Market standard deviation = 0.70
• Covariance of Dover with the market = 0.85
• Dover’s current stock price (P0) = $35.00
• The expected price in one year (P1) is $39.00
• Expected annual dividend = $1.50
• 3-month Treasury bill yield = 4.50%.
• Historical average S&P 500 return = 12.0%.

Dover Holdings stock is:

A) overvalued by approximately 1.8%.

B) undervalued by approximately 2.1%.

C) undervalued by approximately 1.8%.

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To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).
Step 1: Calculate Expected Return (Holding period return)
The formula for the (one-year) holding period return is:
HPR = (D1 + S1 – S0) / S0, where D = dividend and S = stock price.
Here, HPR = (1.50 + 39 – 35) / 35 = 15.71%
Step 2: Calculate Required Return
The formula for the required return is from the CAPM: RR = Rf + (ERM – Rf) × Beta
Here, we are given the information we need except for Beta. Remember that Beta can be calculated with: Betastock = [covS,M] / [σ2M]. Here we are given the numerator and the denominator, so the calculation is: 0.85 / 0.702 = 1.73. RR = 4.50% + (12.0 – 4.50%) × 1.73 = 17.48%.
Step 3: Determine over/under valuation
The required return is greater than the expected return, so the security is overvalued.
The amount = 17.48% − 15.71% = 1.77%.