Stock A has a beta of 1.19 and an expected rate of return of 13.42 percent. The market risk premium is 8.2 percent and the risk-free rate is 4.1 percent. Which one of the following statements related to Stock A is correct? WHY?

a) stock A is overpriced?

b) Stock A is underpriced?

The correct answer is (a) stock A is overpriced, this is because the actual rate of return is lesser than the intrinsic return rate.

Explanation:

Solution

Given that:

Stock A has beta of = 1.19

Expected rate of return = 13.42%

Market premium risk = 8.2%

Risk free rate is = 4.1%

Now

The expected rate return = risk-free rate + beta * (market risk premium)

=4.1 + 1.19*8.2

= 13.858%

Therefore, the stock A is overpriced because the actual rate of return is lower than the intrinsic return rate.