Which one of the following stocks is correctly priced if the risk-free rate of return is 3.9 percent and the market risk premium is 8.4 percent?

Stock Beta Expected Return

A 0.77 7.86%

B 1.55 12.65%

C 1.36 17.33%

D 1.33 11.93%

E 0.95 11.88%

E 0.95 11.88%

Explanation:

First we have to calculate the market return from market risk premium using the following formula:

Market risk premium=Market return-Risk free return

Market return=3.9%+8.4%=12.3%

Above market return will be applied to the Capital asset pricing model formula for the purpose of calculating expected return.

CAPM=Risk free return+Beta (Market return-Risk free return)

A.

Expected return=3.9%+0.77 (12.3%-3.9%) = 10.37%

Incorrect because the expected return is 10.37% as compared to the 7.86% given in question.

B.

Expected return=3.9%+1.55 (12.3%-3.9%) = 16.92%

Incorrect because the expected return is 16.92% as compared to the 12.65% given in question.

C.

Expected return=3.9%+1.36 (12.3%-3.9%) = 15.32%

Incorrect because the expected return is 15.32% as compared to the 17.33% given in question.

D.

Expected return=3.9%+1.33 (12.3%-3.9%) = 15.072%

Incorrect because the expected return is 15.072% as compared to the 11.93% given in question.

E.

CAPM=3.9%+0.95 (12.3%-3.9%) = 11.88%

Correct because the expected return is 11.88% as given in question.

So the correct option is E.