Question

You are analysing a share which has a beta of 1.28. The? risk-free rate is 4.6 %and you estimate the market risk premium to be 7.9 %. If you expect the share to have a return of 10.4% over the next? year what is the expected return, should you buy? it? Why or why? not?

Answer 1

Solution:
	Expected return of the stock	14.71%
	NO, we should not buy this stock.
Working Notes:
	using CAPM relation.
	Ke= rf + (rm - rf ) Be
	Ke= Expected return of the stock =???
	rf= risk free rate = 4.6%
	rm - rf = market risk premium = 7.9%
	Be= beta of the stock= 1.28
	Ke= rf + (rm - rf ) Be
	Ke= 4.6% + 7.9% x 1.28
	Ke= 4.6% + 10.112%
	Ke= 14.712%
	Expected return of the stock = 14.71%
Since,	for beta = 1.28 , our expected return should be 14.71%, but as per our expectation the share to have a return of 10.4% over the next? year , which will be lower return for risk we will take if we buy the stock. As the expected return of stock as per its risk should be 14.71%, but we expect it will give only 10.4%, So we should not invest in this stock.
Please feel free to ask if anything about above solution in comment section of the question.