Question

Jay is reviewing his portfolio of​ investments, which include certain stocks and bonds. He has a large amount tied up in U.S. Treasury bills paying 2.9% . He is considering moving some of his funds from the​ T-bills into a stock. The stock has a beta of 1.21. If Jay expects a return of 14.3% from the stock​ (a little better than the current market return of 12.1%), should he buy the stock or leave his funds in the​ T-bill?

Answer 1

He should buy the fund if the stock is undervalued.

CAPM equation can be used to find the required rate on the stock which will be compared to actual or estimated return to find the undervaluation or overvaluation of the stock.If the required rate of return is greater than the estimated return, then the stock is overvalued or vice versa.

CAPM equation -
E(Ri) = Rf + ( E(Rm) - Rf ) * beta of security

where,
E(Ri) = Required return on security i
rf = risk free return
E(Rm) = Expected market return

Here,

Risk free return = Return on Treasury bills which is 2.9%

Beta of stock = 1.21

Market return = 12.1%

According to CAPM equation -

E(Ri) = Rf + ( E(Rm) - Rf ) * beta of security

E(Ri) = 2.9 + ( 12.1 - 2.9)*1.21

= 2.9 + 9.2*1.21

= 2.9 + 11.132

= 14.032 %

The required return on the stock considering the risk is 14.032 %

and the estimated return on the stock is 14.3% which is greater than the required return according to CAPM eq, hence the stock should be bought.

​​​​​​​Hope it helps!