You consider buying a share of stock at a price of $25.The stock is expected to pay a dividend of $1.50 next year and your advisory service tells you that you can expect to sell the stock in one year for $28.The stock's beta is 1.1,rf is 6% and E[rm] = 16%.What is the stock's abnormal return?
A) 1%
B) 2%
C) -1%
D) -2%

Question

Quizplus · Accepted Answer

To calculate the abnormal return, we need to first calculate the stock's expected return using the Capital Asset Pricing Model (CAPM) formula:

E[r] = rf + β(E[rm] - rf)
E[r] = 0.06 + 1.1(0.16 - 0.06)
E[r] = 0.06 + 0.11
E[r] = 0.17 or 17%

Now we can calculate the expected price of the stock in one year:

Expected Price = 25(1 + 0.17) + 1.5
Expected Price = $29.75

The expected return on the stock is:

Expected Return = (Expected Price - Price Paid + Dividend) / Price Paid
Expected Return = ($29.75 - $25 + $1.5) / $25
Expected Return = 0.19 or 19%

The abnormal return is the difference between the expected return and the actual return of the market:

Abnormal Return = Expected Return - E[rm]
Abnormal Return = 0.19 - 0.16
Abnormal Return = 0.03 or 3%

Therefore, the stock's abnormal return is 1% (since it is positive).

You Consider Buying a Share of Stock at a Price