An analyst predicts that the return on Royal Company stock will be 15%. The analyst is provided with the following data for Royal and the broad market:
Royal Company beta 1.5 -
Risk-free rate 5%
Expected market return 11 %
From the data, determine if Royal Company stock is undervalued, overvalued, or correctly valued.
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A. B. C.B
To determine if Royal Company stock is undervalued, overvalued, or correctly valued, we need to compare the expected return of the stock with its required return based on the risk associated with the stock.
The required return of a stock is calculated using the Capital Asset Pricing Model (CAPM), which takes into account the risk-free rate, the expected market return, and the beta of the stock. The formula for calculating the required return using CAPM is as follows:
Required Return = Risk-free Rate + Beta × (Expected Market Return - Risk-free Rate)
Given the provided data:
We can now calculate the required return for Royal Company stock:
Required Return = 5% + 1.5 × (11% - 5%) Required Return = 5% + 1.5 × 6% Required Return = 5% + 9% Required Return = 14%
The required return for Royal Company stock, based on its beta and the market conditions, is 14%.
Now, let's compare the required return with the predicted return of 15% provided by the analyst.
If the predicted return is higher than the required return, the stock would be considered undervalued because it is expected to generate a higher return than what is required given its risk. In this case, the predicted return of 15% is higher than the required return of 14%.
Therefore, based on the provided data, Royal Company stock would be considered undervalued (option B) since the predicted return exceeds the required return.