A friend has some reliable information that the stock of Puddles Company is going to rise from $43.00 to $50.00 per share over the next year. You know that the annual return on the S&P/TSX composite index has been 11% and the 90-day T-bill rate has been yielding 5% per year over the past 10 years. If beta for Puddles is 1.5, will you purchase the stock?
A) Yes, because it is overvalued.
B) Yes, because it is undervalued.
C) No, because it is undervalued.
D) No, because it is overvalued.
E) Yes, because the expected return equals the estimated return.

Question

Quizplus · Accepted Answer

Expected Return = 5 + (1.5)(11 - 5) = 14.0%
Estimated Return = (50 - 43) ¸ 43 = 16.28%
Estimated Return > Expected Return
\ Stock is undervalued and should be purchased.

A Friend Has Some Reliable Information That the Stock of Puddles