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CMA Final · Strategic Financial Management · Asset Pricing Theories

A share is priced to give an expected return of 14% under the CAPM. The risk-free rate is 5% and the market risk premium is 6%. Analysts forecast a return of 15.5% on the share. What is the share's beta and Jensen's alpha?

Beta is 1.5 and alpha is +1.5%. The CAPM return of 14% less the 5% risk-free rate leaves a 9% premium, which divided by the 6% market premium gives beta 1.5. The forecast of 15.5% exceeds 14% by 1.5%, indicating an undervalued share.

  1. ABeta 1.5; alpha +1.5%Correct
  2. BBeta 1.5; alpha -1.5%
  3. CBeta 1.8; alpha +1.5%
  4. DBeta 1.0; alpha +0.5%

Explanation

Required return 14% = 5% + beta x 6%, so beta = 9/6 = 1.5. Alpha = forecast return - CAPM return = 15.5% - 14% = +1.5%, so the share is undervalued. The negative alpha option reverses the subtraction.

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