Question

a. Suggest an example of an asset with zero beta. Explain whether an asset with zero beta offers an expected return of zero.

b. Milton considers buying the ABC stock. The ABC stock pays a constant dividend of $5 in perpetuity, and the beta of the ABC stock is 1.2. The risk-free rate is 4%, and the expected market return is 12%.

i. Compute the price of the ABC stock based on the CAPM.

ii. Suppose the market price of the ABC stock is $40. According to the CAPM, is the stock over-priced or under-priced? Should he buy the ABC stock? Explain.

Please write in full steps thx!

Answer 1

Question A:

Zero Beta stocks refers to the stocks that has no correlation with the market means they show no movement in the prices whether the market goes upward or downward, they do offer return but it is equivalent to the risk free return. In these stocks, the expected return is the risk free return. These types of stocks are considered as risk free as they don't correlate with market but they do have very low rate of returns.

Question B:

1. According to the CAPM,

Cost of capital / required return = Rf + B(Rm -Rf)

Where, Rf is risk free security

B is beta

Rm is market return

= 4% + 1.2 (12% - 4%)

= 4% + 1.2 (8%)

Cost of capital = 13.6%

When the share gives dividend in perpetuity, then we use formulae of constand dividend growth model which says,

Price of share = Dividend / Cost of capital

= 5 / 13.6%

= $36.76

Price per share based on CAPM is $36.76

2. The market price of the share is $40 while the intrinsic worth of the share is $36.76, This means the share is overpriced in the market than it's fair value. This means the company is giving more return than the reuired return by the investors and investors are expecting that the company has huge growth potential. So, he should buy the stock according to CAPM.