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Valuing A Stock Using CAPM

Suppose the risk free rate is 4%. Suppose also that the expected return required by the market for a portfolio with a beta of 1.0 is 9%. Suppose you consider buying a share of stock at a price of $42. The stock is expected to pay a dividend of $3 next year and to sell then for $41. The stock risk has been evaluates at beta of 1.2.

(a) Is the stock overpriced or underpriced according to the capital asset pricing model?

(b) What might be the (current) fair price of the stock?

Solution Preview

The Capital Asset Pricing Model states that the rate of return of a stock=the risk-free rate+(beta*(the market rate of return-the risk-free rate). The excess of the market rate of return over the risk-free rate is called the market premium. Therefore, the rate of ...

Solution Summary

Given the components of the capital asset pricing model and a stock's current and expected price, as well as its expected dividend, this solution illustrates how to value the stock using the capital asset pricing model, how to determine its total return, and how to determine if it is fairly priced by comparing the two computations.