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26 January, 15:36

Which one of the following stocks is correctly priced if the risk-free rate of return is 3.9 percent and the market risk premium is 8.4 percent?

Stock Beta Expected Return

A 0.77 7.86%

B 1.55 12.65%

C 1.36 17.33%

D 1.33 11.93%

E 0.95 11.88%

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Answers (1)
  1. 26 January, 15:50
    0
    E 0.95 11.88%

    Explanation:

    First we have to calculate the market return from market risk premium using the following formula:

    Market risk premium=Market return-Risk free return

    Market return=3.9%+8.4%=12.3%

    Above market return will be applied to the Capital asset pricing model formula for the purpose of calculating expected return.

    CAPM=Risk free return+Beta (Market return-Risk free return)

    A.

    Expected return=3.9%+0.77 (12.3%-3.9%) = 10.37%

    Incorrect because the expected return is 10.37% as compared to the 7.86% given in question.

    B.

    Expected return=3.9%+1.55 (12.3%-3.9%) = 16.92%

    Incorrect because the expected return is 16.92% as compared to the 12.65% given in question.

    C.

    Expected return=3.9%+1.36 (12.3%-3.9%) = 15.32%

    Incorrect because the expected return is 15.32% as compared to the 17.33% given in question.

    D.

    Expected return=3.9%+1.33 (12.3%-3.9%) = 15.072%

    Incorrect because the expected return is 15.072% as compared to the 11.93% given in question.

    E.

    CAPM=3.9%+0.95 (12.3%-3.9%) = 11.88%

    Correct because the expected return is 11.88% as given in question.

    So the correct option is E.
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