A stock has a beta of 1.25. The risk-free rate is 5 percent and the return on the market is 6 percent. The estimated return for the stock is 14 percent. According to the CAPM, you should
A) sell because it is overvalued.
B) sell because it is undervalued.
C) buy because it overvalued.
D) buy because it is undervalued.
E) short because it is undervalued.

Question

Quizplus · Accepted Answer

The estimated return of the stock (14%) is higher than the expected return calculated using the CAPM formula (r = rf + β(rm - rf) = 5% + 1.25(6% - 5%) = 6.25%). Therefore, the stock is undervalued and should be purchased.

A Stock Has a Beta of 1