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CMA Intermediate · Financial Management and Business Data Analytics · Risk and Return

Risk-free rate is 6% and market return is 11%. A stock with beta 0.8 is expected to return 9.5%. Its CAPM required return is 10%. The stock is:

The stock is overvalued. CAPM gives a required return of 10% (6% plus 0.8 times 5%), but the stock is expected to earn only 9.5%. Since it offers less than the return needed for its risk, it lies below the security market line.

  1. AUndervalued, since expected return exceeds required return
  2. BCorrectly priced, since beta is below 1
  3. COvervalued, since expected return is below required returnCorrect
  4. DUndervalued, since beta is below 1

Explanation

Required return = 6 + 0.8 × 5 = 10%. Expected return of 9.5% is below 10%, so the stock plots below the Security Market Line and is overvalued. Beta below 1 alone does not decide valuation.

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