Question

1. You have $20,000. After the “success” of the sequel of the “Hunger Games”, you want to know if Lions Gate Entertainment Corp. (NYSE:LGE) is a good buy. The firm’s total risk is 19%, its systematic risk is 0.57, the t-bill rate is 2.0%, the 30 year treasury rate is 3.5%, and the average market return is 8.8%.
   1. What is the expected return on Lions Gate Entertainment Corp?
   2. Assume you constructed a DCF model to evaluate Lions Gate Entertainment Corp and you found that the current market price of the stock implies an expected return of 8.05% [Note: You do not actually have to do a DCF model for this problem]. Given you answer in part (a), is the firm overvalued, undervalued, or properly priced? Explain.

2. You are considering an investment in firm ABC. You know the risk free rate is 3.5%, the expected return on the market portfolio is 8.8%, and the standard deviation of the market portfolio is 15.35%. You also know that stock ABC has a standard deviation of 45.3% but it is uncorrelated with the market portfolio.
   1. What is the beta of stock ABC?
   2. According to the CAPM, what is the expected return on stock ABC?
   3. You know that firm ABC has a higher standard deviation than the market portfolio. How do you explain the return in part (b) and the fact that is has a high standard deviation? In particular, what do you know about the risk?

Answer 1

Ans 1 - A

According to Capital Asset Pricing Model (CAPM) –

         Expected Return of a stock =   Risk free rate + Beta ​∗ (Expected return of market-risk free rate)

                                Ra​ =     Rrf​ + βa​∗ (Rm​−Rrf​)

                                       =      3.5 + .57 (8.8-3.5) (here beta= systematic risk of stock in                    

                                       =       6.521 %

Ans 1 B   As the current market value implies return of 8.05 % as per DC valuation -

8.05 % > 6.521 % ( The stock is overvalued)

Ans 2 A- Beta of stock ABC = Correlation of Stock with market ​∗ Security standard deviation of return/ Market standard deviation of return

= -45.3 (as there is uncorrelation) ​∗ 45.3/15.35

= -1.3363

Ans 2 B - Here the beta is -1.3363 which means the stock returns are inversely related to market performance, the risk in this stock is high as their is higher standard deviation. Overall the total risk of this stock is negatively related to portfolio.