Question

The risk-free rate of return is 4 percent, and the market return is 10 percent. The betas of Stocks A, B, C, D, and E are 0.85, 0.95, 1.20, 1.35, and 0.5, respectively. The expected rates of return for Stocks A, B, C, D, and E are 8%, 9%, 10%, 14%, and 6%, respectively. Which stock should a rational investor purchase?

Answer 1

D

Step-by-step explanation:

We have to determine the required rate of return

The required rate of return can be determined using the CAPM

Required return = risk free rate + (beta x market risk premium)

Market risk premium = market return - risk free rate = 10% - 4% = 6%

A = 4% + (0.85 x 6%) = 9.1%

B = 4% + (0.95 x 6%) = 9.7%

C = 4% + (1.2 x 6%) = 11.2%

D = 4% + (1.35 x 6%) = 12.1%

E = 4% + (0.5 x 6%) = 7%

Of the 5 stocks, stock D has a higher expected return compared to the required return and a rational investor would purchase this stock