CMA Final · Strategic Financial Management · Asset Pricing Theories
Stock Kaveri Ltd has an expected return of 15% and a beta of 1.2. The risk-free rate is 7% and the market return is 13%. What is Jensen's alpha as per CAPM, and how is the stock placed?
Alpha is +0.8%. The CAPM required return is 7% plus 1.2 times 6%, which is 14.2%. Since the expected return of 15% exceeds this, the stock plots above the security market line and is undervalued, so it is a buy candidate.
- A+0.8%; undervalued, lies above the SMLCorrect
- B-0.8%; overvalued, lies below the SML
- C+2.0%; undervalued, lies above the SML
- D0.0%; fairly priced, lies on the SML
Explanation
Required return = 7 + 1.2 x 6 = 14.2%. Alpha = 15 - 14.2 = +0.8%. A positive alpha means the expected return exceeds the required return, so the stock plots above the SML and is undervalued. The +2.0% option wrongly uses 13% as the required return.
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