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?
A) Yes, because it is overvalued.
B) No, because it is overvalued.
C) No, because it is undervalued.
D) Yes, because it is undervalued.
E) Yes, because the expected return equals the estimated return.

Question

Quizplus · Accepted Answer

DTo determine whether to purchase the stock, we need to calculate the expected return based on the Capital Asset Pricing Model (CAPM) and compare it to the actual estimated return. The CAPM formula is: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).Given:- Risk-Free Rate (90-day T-bill rate) = 3.75%- Beta for Bubbly = 0.85- Market Return (annual return on the S&P 500) = 9.25%Plugging these values into the CAPM formula gives:Expected Return = 3.75% + 0.85 * (9.25% - 3.75%) = 3.75% + 0.85 * 5.5% = 3.75% + 4.675% = 8.425%The estimated return based on the stock price increase from $57 to $61 is:Estimated Return = (61 - 57) / 57 = 4 / 57 ≈ 7.02%Since the expected return (8.425%) is higher than the estimated return (7.02%), the stock is overvalued according to the CAPM, suggesting not to buy (B). However, there is no option indicating the stock is overvalued and suggesting a purchase; thus, the explanation provided addresses the correct reasoning for not purchasing the stock due to it being overvalued.

Recently You Have Received a Tip That the Stock of Bubbly