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CMA Final · Strategic Financial Management · Asset Pricing Theories

On the Security Market Line, the risk-free rate is 7% and the market return is 14%. Rohit Pharma Ltd has an expected return of 17.5% from fundamental analysis and a beta of 1.4. Which conclusion is correct?

The share is undervalued, plotting 0.7% above the SML. The SML return is 7% plus 1.4 times the 7% market premium, i.e. 16.8%, while the expected return is 17.5%, so the excess is 0.7%.

  1. AFairly priced since beta exceeds 1
  2. BOverpriced, as its return is below the SML return
  3. CUndervalued, as it plots above the SML by 0.7%Correct
  4. DUndervalued, as it plots above the SML by 2.5%

Explanation

SML return = 7% + 1.4 x 7% = 16.8%. Expected return 17.5% exceeds this by 0.7%, so the share plots above the SML and is undervalued. The 2.5% option compares with the market premium incorrectly (17.5 - 14 - 1).

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