Question

The risk free rate is 5% and the market rate of return is 8%. Stock A has a beta value =0.5.

Required:

(A). Draw the Security Market Line (SML) clearly indicating the risk free asset, market and stock A.[12marks].(B) Stock A beginning price is K50 and during the year paid a dividend of k3 with a maturity value of k55. Show using an empirical evidence weather stock A is undervalued, overvalued of fairly valued.[8marks]

Answer 1

The Security Market Line (SML) plots the stock's expected return vy varying its beta value

The required rate of return R(e) is calculated by CAPM model

R(e) = r(f) + Beta*(R(m) - r(f))

R(m) is the market return = 8%

r(f) is the risk-free rate = 5%

R(e) = 0.05+Beta*(0.08-0.05)

Beta	Required return
0	0.05
0.1	0.053
0.2	0.056
0.3	0.059
0.4	0.062
0.5	0.065
0.6	0.068
0.7	0.071
0.8	0.074
0.9	0.077
1	0.08
1.1	0.083
1.2	0.086
1.3	0.089
1.4	0.092
1.5	0.095
1.6	0.098
1.7	0.101
1.8	0.104
1.9	0.107
2	0.11

B)

Total return of holding stock A for the year = (Total capital gains+ Dividend income for the year)/ Initial value of the stock

Total return of holding stock A for the year = (55-50+3)/50 = 16%

Required return using capm model = r(f) + Beta*(R(m) - r(f)) = 0.05 + 0.5*(0.08-0.05) = 6.5%

Since, the actual return in more than the required rate of return, Stock A is under-valued.