1 The beta of Stock B is 05 indicating that its returns rise

1. The beta of Stock B is –0.5 (indicating that its returns rise when returns on most other stocks fall). If the risk-free rate is 5.2 percent and the expected rate of return on an average stock is 8.9 percent, what is the required rate of return on Stock B?

I know the answer is 3.35%, but I don\'t understand it. May I know step-by-step?

2. Stock B’s beta coefficient is b_B = 1.2. The risk-free rate is 5 percent, and the expected return on an average stock is 11 percent. The current price of Stock B, P₀, is $80; the next expected dividend, D₁, is $3.20; and the stock’s expected constant growth rate is 4 percent. Which of the following is correct?

I know the answer is \"Stock B is overvalued. Its price will fall to restore equilibrium.\" but I don\'t understand why.

Solution

1. required return on stock B = 5.2% - 0.5*(8.9% - 5.2%) = 3.35%

2. required return = 5% + 1.2*(11% - 5%) = 12.2%

expected return = 3.20/80 + 4% = 8%

since the required return is more, the price has to be lesser so that the expected return equals the required return. So the stock is overvalued