QUESTION 23

Moonn is evaluating the expected performance of two common stocks, Harvard, Inc. and Yale, Inc. She has gathered the following information. However, Moonn was not sure which model would be appropriate to value these stocks. Caleb tells Moonn that she should use the Capital Asset Pricing (CAPM)/security market line equation to determine the performance of Harvard, Inc. and Yale, Inc and made the following statement regarding CAPM: The CAPM is an equation for required return that should hold in equilibrium (the condition in which supply equals demand) if the models assumptions are met; among the key assumptions are that investors are risk averse and that they make investment decisions based on the mean return and variance of returns of their total portfolio. The chief insight of the model is that investors evaluate the risk of an asset in terms of the assets contribution to the systematic risk of their total portfolio (systematic risk is risk that cannot be shed by portfolio diversification). Because the CAPM provides an economically grounded and relatively objective procedure for required return estimation, it has been widely used in valuation. The risk-free rate 5 percent The expected return on the market portfolio 11.5 percent The beta of Harvard stock 1.5 The beta of Yale stock 0.8. Andys forecasts of the returns on the Harvard stocks 13.25 percent Andys forecasts of the returns on the Yale stocks 11.25 percent Moon made the following statements regarding the Harvard stock and Yale stock. Statement 7: Using the Security Market Line (SML) equation, I believe both Harvard and Yale stocks are overvalued. With respect to statement 7, Moonn is incorrect:

A. Because CAPM return is 10.20% and the Yale stock is overvalued

B. Because CAPM return is 14.75% and the Harvard stock is undervalued.

C. Because CAPM return is 10.20% and the Yale stock is undervalued.