The expected return on the market portfolio is 15%. The risk-free rate is 8%. The expected return on SDA Corp. common shares is 16%. The beta of SDA Corp. common shares is 1.25. Within the context of the capital asset pricing model, ________.
A)SDA Corp. shares are underpriced
B)SDA Corp. shares are fairly priced
C)SDA Corp. shares' alpha is -0.75%
D)SDA Corp. shares' alpha is 0.75%

Question

Quizplus · Accepted Answer

Using the Capital Asset Pricing Model (CAPM):
Expected Return on SDA Corp. = Risk-free Rate + Beta(S&P 500 Expected Return - Risk-free Rate)
Expected Return on SDA Corp. = 8% + 1.25(15% - 8%)
Expected Return on SDA Corp. = 16%
Since the expected return on SDA Corp. common shares is equal to the calculated expected return, the shares are considered fairly priced. However, the alpha of SDA Corp shares can be calculated by comparing their expected return to their required return. The required return is the risk-free rate plus the beta multiplied by the expected excess return of the market portfolio: 
Required Return = Risk-Free Rate + Beta(Expected Market Return - Risk-Free Rate)
Required Return = 8% + 1.25(15% - 8%)
Required Return = 17.75%
Alpha = Expected Return - Required Return
Alpha = 16% - 17.75%
Alpha = -1.75%
Therefore, the alpha of SDA Corp. shares is -0.75% (not 0.75%).

The Expected Return on the Market Portfolio Is 15