A friend has some reliable information that the stock of Puddles Company is going to rise from $43.00 to $50.00 per share over the next year. You know that the annual return on the S&P 500 has been 11 percent and the 90-day T-bill rate has been yielding 5 percent per year over the past 10 years. If beta for Puddles is 1.5, will you purchase the stock?
A) Yes, because it is overvalued.
B) Yes, because it is undervalued.
C) No, because it is undervalued.
D) No, because it is overvalued.
E) Yes, because the expected return equals the estimated return.

Question

Quizplus · Accepted Answer

We can calculate the expected return on Puddles Company using the Capital Asset Pricing Model (CAPM):
Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

Risk-Free Rate = 5%
Market Return = 11%
Beta = 1.5

Expected Return = 5% + 1.5 * (11% - 5%) = 14%

Since the expected return of 14% is greater than the expected increase in stock price (13.95%, calculated as (50 - 43) / 43), the stock is undervalued and a good buy. Therefore, choice B is the correct answer.

A Friend Has Some Reliable Information That the Stock of Puddles