Assume the risk-free rate is 4.5 percent and the expected return on the market is 11 percent. You anticipate Stock XYZ to sell for $28 at the end of next year and pay a dividend of $2. The stock is currently selling for $26.50 with a beta of 1.2. You currently hold stock XYZ in a well-diversified portfolio. Assuming you have money to invest, you should
A) buy stock XYZ.
B) sell stock XYZ.
C) do nothing because it is properly valued.
D) invest your money in the risk-free rate of return.
E) buy a put option.

Question

Quizplus · Accepted Answer

We need to calculate the expected return for Stock XYZ using the capital asset pricing model (CAPM):
Expected return = risk-free rate + beta * (expected market return - risk-free rate)
Expected return = 4.5% + 1.2 * (11% - 4.5%)
Expected return = 12.6%
Comparing the expected return of 12.6% to the current price of $26.50, we can calculate the intrinsic value:
Intrinsic value = (dividend + expected price) / (1 + required return)
Intrinsic value = ($2 + $28) / (1 + 12.6%)
Intrinsic value = $26.11
Since the intrinsic value is higher than the current price, the stock is undervalued, thus buying stock XYZ would be the best choice.

Assume the Risk-Free Rate Is 4