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Problems on CAPM/SML

1. A share of stock is now selling for $100. It will pay a dividend of $9 per share at the end of the year.
Its beta is 1.0. What do investors expect the stock to sell for at the end of the year if the market expected
return is18% and the risk free rate for the year is 8%?

2. Assume two stocks, A and B. One has that E(rA) = 12% and E( rB) = 15.%. The beta for stock A is
0.8 and the beta for B is 1.2. If the expected returns of both stocks lie in the SML line, what is the
expected return of the market and what is the risk-free rate?

3. Suppose that returns on Durham Company have a covariance with the market of 0.0635 and that the
variance of the market returns is 0.04326. The market risk premium is 9.4 percent and the expected
return on Treasury bills is 4.9 percent. What is the required return of Durham Company?

4. A share of stock with a beta of .75 now sells for $50. Investors expect the stock to pay a year-end
dividend of $2. The T-bill rate is now 4 percent, and the market risk-premium is 8 percent. (a) If the
stock is perceived to be fairly priced today, what must be investors expectation of the stock price at the
end of the year?
(b) Suppose investors actually believe the stock will sell for $54 at year-end. Is the stock a good or bad
buy? What will investors do? At what price will the stock reach an equilibrium at which it is again
perceived to be fairly priced?

5. Wilson is now evaluating the expected performance of two common stocks, Furhman Labs Inc. and
Garten Testing Inc. He has gathered the following information:
- The Risk free rate is 5%; The expected return on Market portfolio is 11.5%
- The beta of Furhman stock is 1.5; the beta of Garten stock is .8
Based on his own analysis, wilsons forecasts of the returns of the two stocks are 13.25% for Furhman
stock and 11.25% for Garten stock. Calculate the required rate of return for Furhman Labs stock and
for Garten Testing stock. Indicate whether each stock is undervalued, fairly valued, or overvalued.

6. Within the context of the CAPM, assume:


- Expected return on the market = 15%; Risk-free rate = 8%
- Expected rate of return on XYZ security = 17%; Beta of XYZ = 1.25
Which one of the following is correct?

a) XYZ is overpriced b) XYZ is fairly priced


c) XYZs alpha is -.25% d) XYZs alpha is .25%