Question

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM

You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also have the following information about three stocks.

		Current	Expected	Expected
Stock	Beta	Price	Price	Dividend
X	1.25	$20	$23	$1.25
Y	1.50	$27	$29	$0.25
Z	0.90	$35	$38	$1.00

Refer to Exhibit 7.2. What is your investment strategy concerning the three stocks?

a. buy X, Y, and Z

b. sell X, Y, and Z

c. buy X and Y; sell Z

d. buy X and Z; sell Y

e. sell X and Z; buy Y

Answer 1

Actual Rate of Ret:

= [ D1 + P1 - P0 ] / P0

X:

= [ D1 + P1 - P0 ] / P0

[ $ 1.25 + $ 23 - $ 20 ] / $ 20

= $ 4.25 / $ 20

= 0.2125 i.e 21.25%

Y:

= [ D1 + P1 - P0 ] / P0

= [ $ 0.25 + $ 29 - $ 27 ] / $ 27

= $ 2.25 / $ 27

= 0.0833 i.e 8.33%

Z:

= [ D1 + P1 - P0 ] / P0

= [ $ 1.00 + $ 38 - $ 35 ] / $ 35

= $ 4 / $ 35

= 0.1143 i.e 11.43%

Required Ret :

Rf + Beta [ Rm - Rf ]

X:

Expected Ret = Rf + Beta [ Rm - Rf ]

= 3% + 1.25 [ 8% - 3% ]

= 3% + 1.25 [ 5% ]

= 3% + 6.25%

= 9.25%

Y:

Expected Ret = Rf + Beta [ Rm - Rf ]

= 3% + 1.50 [ 8% - 3% ]

= 3% + 1.50 [ 5% ]

= 3% + 7.50%

= 10.50%

Z:

Expected Ret = Rf + Beta [ Rm - Rf ]

= 3% + 0.9 [ 8% - 3% ]

= 3% + 0.9 [ 5% ]

= 3% + 4.50%

= 7.50%

If Exepected Ret > Actual Ret - Sell,

If Expected Ret < Actual ret - Buy.

Project	Actual Ret	Expected Ret	Buy/ Sell
X	21.25%	9.25%	Buy
Y	8.33%	10.50%	Sell
Z	11.43%	7.50%	Buy

Option D is correct.