Recently your broker has advised you that he believes that the stock of Casey Incorporated is going to rise from $55.00 to $70.00 per share over the next year. You know that the annual return on the S&P 500 has been 12.5 percent and the 90-day T-bill rate has been yielding 6 percent per year over the past 10 years. If beta for Casey is 1.3, 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

According to the information provided, the expected return on the market is 12.5%, and the risk-free rate is 6%. Using the Capital Asset Pricing Model (CAPM), the required rate of return for Casey is:

= Rf + β x (Rm - Rf)
= 6% + 1.3 x (12.5% - 6%)
= 16.5%

Since the expected return of 37.5% ([$70 - $55] / $55) is greater than the required return of 16.5%, the stock is undervalued and a good investment opportunity. Therefore, the best choice is B - Yes, because it is undervalued.

Recently Your Broker Has Advised You That He Believes That