Question

Recently you have received a tip that the stock of Bubbly Incorporated is going to rise

from $57 to $61 per share over the next year. You know that the annual return on the
S&P 500 has been 9.25 percent and the 90-day T-bill rate has been yielding 3.75 percent
per year over the past 10 years. If beta for Bubbly is 0.85, will you purchase the stock?

Answer 1

Answer: b. No, because it is overvalued.

Explanation:

Check for the Required return first which according to CAPM is;

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

= 3.75% + 0.85(9.25% - 3.75)

= ‭0.08425‬

= 8.43%

Then calculate the Expected return;

= (New price + dividends - Old price) / Old price

= (61 - 57) / 57

= 0.070175

= 7.02%

The Expected return is lower than the Required return for this stock. This means that the stock is overvalued and so you should not buy it.