USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Stocks A, B, and C have two risk factors with the following beta coefficients. The zero-beta return ($\lambda$0) = .025 and the risk premiums for the two factors are ($\lambda$1) = .12 and ($\lambda$0) = .10.

-Refer to Exhibit 7.10. Suppose that you know that the prices of stocks A, B, and C will be $10.95, 22.18, and $30.89, respectively. Based on this information,
A) all three stocks are overvalued.
B) all three stocks are undervalued.
C) stock a is undervalued, stock b is properly valued, and stock c is undervalued.
D) stock a is undervalued, stock b is properly valued, and stock c is overvalued.
E) stock a is overvalued, stock b is overvalued, and stock c is undervalued.

Question

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Stocks A, B, and C have two risk factors with the following beta coefficients. The zero-beta return ($\lambda$0) = .025 and the risk premiums for the two factors are ($\lambda$1) = .12 and ($\lambda$0) = .10.
 
-Refer to Exhibit 7.10. Suppose that you know that the prices of stocks A, B, and C will be $10.95, 22.18, and $30.89, respectively. Based on this information,
A) all three stocks are overvalued. 
B) all three stocks are undervalued. 
C) stock a is undervalued, stock b is properly valued, and stock c is undervalued. 
D) stock a is undervalued, stock b is properly valued, and stock c is overvalued. 
E) stock a is overvalued, stock b is overvalued, and stock c is undervalued.

Quizplus · Accepted Answer

To determine whether a stock is undervalued or overvalued, we need to compare its actual price to its fair value as calculated using the Capital Asset Pricing Model (CAPM):
CAPM = Risk-Free Rate + Beta * Market Risk Premium
For stock A, the CAPM is:
CAPM = 0.025 + 0.5 * 0.12 + 0.6 * 0.10 = 0.082
Fair value = Dividend / (1 + CAPM) + Price in 1 year / (1 + CAPM)^2
Assuming no dividend, fair value = 10.95 / (1 + 0.082) + 10.95 * 1.05 / (1 + 0.082)^2 = 11.89
Since the fair value is higher than the actual price, stock A is undervalued.
We can perform similar calculations for stocks B and C to get their fair values:
Stock B: Fair value = 22.18 / (1 + 0.19) + 22.18 * 1.10 / (1 + 0.19)^2 = 25.75, which means it is undervalued.
Stock C: Fair value = 30.89 / (1 + 0.28) + 30.89 * 1.20 / (1 + 0.28)^2 = 38.44, which means it is undervalued.
Therefore, the best choice is C: stock A is undervalued, stock B is undervalued, and stock C is undervalued.

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S) Stocks A λ\lambdaλ

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
Stocks A $\lambda$