Your broker has advised you that he believes that the stock of Brat Inc. is going to rise from $20 to $22.15 per share over the next year. You know that the annual return on the S&P 500 has been 11.25 percent and the 90-day T-bill rate has been yielding 4.75 percent per year over the past 10 years. If beta for Brat is 1.25, 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 Brat Inc. stock, we need to calculate its expected return and compare it to the required return based on the Capital Asset Pricing Model (CAPM). The expected return based on the broker's advice is from $20 to $22.15, which is a (22.15 - 20) / 20 = 10.75% return. The CAPM formula is: Required return = Risk-free rate + Beta * (Market return - Risk-free rate). Plugging in the given values: Required return = 4.75% + 1.25 * (11.25% - 4.75%) = 4.75% + 1.25 * 6.5% = 4.75% + 8.125% = 12.875%.Since the expected return of 10.75% is less than the required return of 12.875%, the stock is overvalued according to CAPM, suggesting not to buy (B). However, there's a mistake in the options provided as they contradict each other; option D suggests buying because it's undervalued, which is incorrect based on the calculation. The correct stance based on the calculation is not to buy because it's overvalued.

Your Broker Has Advised You That He Believes That the Stock