Question

Taylor, Inc., stock has a beta of 1.2 and an expected return of 9.3%. The risk-free rate is 4.1% and the market risk premium is 6.8%. This stock is _____ because the CAPM return for the stock is _____%.a. overvalued; 11.87.

b. undervalued; 12.09.
c. undervalued; 12.26.
d. overvalued; 12.26.
e. undervalued; 11.87.

Answer 1

The stock is overvalued because the CAPM return for the stock is 12.26%

Option d is the correct answer.

Step-by-step explanation:

Using the CAPM, we can calculate the required rate of return on a stock. This is the minimum return required by the investors to invest in a stock based on its systematic risk, the market's risk premium and the risk free rate. If the expected return on a stock is less than the required rate of return, a stock is said to be overvalued and vice versa.

The formula for required rate of return under CAPM is,

r = rRF + Beta * rpM

Where,

rRF is the risk free rate

rpM is the market return

r = 0.041 + 1.2 * 0.068

r = 0.1226 or 12.26%

The stock is overvalued because the CAPM return for the stock is 12.26%