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CA Final · Integrated Business Solutions (Multidisciplinary Case Study with Strategic Management) · Advanced Financial Management

Case: Meridian Asset Advisors is evaluating Equity X for a client portfolio. The risk-free rate is 7%, the expected market return is 12%, and Equity X has a beta of 1.4. Analysts forecast a return of 15% on Equity X. Using CAPM, what is the required return and the alpha of Equity X?

CAPM required return is 7% plus 1.4 times the 5% market premium, giving 14%. The forecast return of 15% exceeds this by 1%, so alpha is positive 1%. The stock lies above the security market line and is considered underpriced.

  1. ARequired return 14%; alpha +1%Correct
  2. BRequired return 14%; alpha -1%
  3. CRequired return 16.8%; alpha -1.8%
  4. DRequired return 12%; alpha +3%

Explanation

Required return = 7% + 1.4 x (12% - 7%) = 7% + 7% = 14%. Alpha = expected 15% - required 14% = +1%, so the stock plots above the SML and is underpriced. Rs 16.8% results from wrongly adding beta x market return (1.4 x 12%) without deducting the risk-free rate.

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