Question

The expected return on the market portfolio is 18%. The risk-free rate is 10%. The expected return on SDA Corp. common stock is 17%. The beta of SDA Corp. common stock is 1.25. Within the context of the capital asset pricing model, _________.

Answer 1

Using the Capital Asset Pricing Model (CAPM), the expected return for SDA Corp. should be 20%. The stock may be underpriced as its actual expected return is 17%, lower than the CAPM value.

Step-by-step explanation:

The question posed relates to the Capital Asset Pricing Model (CAPM) which calculates the expected return of a security based on its risk in relation to the market. In this instance, SDA Corp. has an expected return of 17%, a beta of 1.25, the risk-free rate is 10%, and the expected return on the market portfolio is 18%. According to CAPM, the expected return on a security is the risk-free rate plus the product of the security's beta and the market risk premium (the difference between the market return and the risk-free rate).

To better understand this concept, let's calculate the expected return using the CAPM formula:

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

Inserting the given values we get:

Expected return = 10% + (1.25 × (18% - 10%))

Expected return = 10% + (1.25 × 8%)

Expected return = 10% + 10%

Expected return = 20%

Comparing this to the actual expected return of SDA Corp. (17%), we can see that SDA Corp.'s common stock may be underpriced, according to CAPM, because its expected return is lower than what CAPM suggests it should be, implying the potential for a higher actual rate of return.