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6 September, 06:28

Suppose the risk-free rate is 8%. The expected return on the market is 14%. Given this data, answer the following questions: If a particular stock has a beta of. 6, what is its expected return based on the CAPM? If another stock has an expected return of 20%, what must its beta be? If a stock has a beta of 1.3 and a current return of 17%, what can you say about the stock's current price? What direction would you expect the stock price to move?

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  1. 6 September, 07:29
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    a.) Return of stock;

    CAPM; r = risk-free + Beta (Market return - risk-free)

    risk free rate = 8% or 0.08 as a decimal

    Beta = 0.6

    Market return = 14% or 0.14

    CAPM; r = 0.08 + 0.6 (0.14 - 0.08)

    return; r = 0.116 or 11.6%

    b.) If return (r) is 20%;

    CAPM; r = risk-free + Beta (Market return - risk-free)

    return (r) = 20% or 0.20 as a decimal

    risk free rate = 8% or 0.08 as a decimal

    Market return = 14% or 0.14

    Beta = ?

    0.20 = 0.08 + Beta (0.14 - 0.08)

    0.20 - 0.08 = 0.06Beta

    0.12 = 0.06Beta

    Divide both sides by 0.06

    0.12/0.06 = Beta

    Beta = 2

    c.) If a stock has a beta of 1.3 and a current return of 17%, what can you say about the stock's current price?

    Using CAPM, the return should be;

    CAPM; r = risk-free + Beta (Market return - risk-free)

    r = 0.08 + 1.3 (0.14 - 0.08)

    r = 0.158 or 15.8%

    Since the current return of 17%, is lower than the CAPM return of 15.8%, it means that the current stock price is undervalued

    Direction? The stock is expected to go up eventually since there will be a higher demand in the market due to the lower price than the actual intrinsic value.
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