Two stocks, onehigh risk (H)and onelow risk (L), have been evaluated by the financial analysts for your investment firm. Your team of analysts have estimated that the high-risk stock (H) will probably earn a 36% return this year, and the low risk stock (L) will most likely earn a return of 22% this year. Thebetafor the high-risk (H) stock is 1.3. Thebetafor the low-risk (L) stock is 0.80. Your job as team leader is to apply the CAPM equation to these companies to determine whether they are undervalued or overvalued and whether you shouldbuythem orsell them short. You must use the SML to determine what you should do. The risk-free rate is 3.5%. The expected return on the market index is 30% .

a. Using the CAPM equation, calculate the risk-adjusted required rate of return for H and L.Show your work (i.e. how you get our numbers)

b.Tell me whether you should buy (or sell short) stock H, and why. Tell me whether you should buy (or sell short) stock L, and why. You explanation for whether you should buy (or sell short) the stock must be the correct explanation based on what we learned in this Module.

c. Draw a single Security Market Line (SML) graph(like I did in the lesson video)and place stock H and stock L on the graphin the appropriate location that would justify your answers in part (b)of this question. That meanslabelingboth axis correctly, identifying where themarket return and market betais, and then identifying where stock H and L would be on the graph (theirbetaand CAPM risk-adjusted required rate of return). Then place thereturns that your financial analysts team estimated for stocks H and L in the appropriate place on the graphthat would justify your decision to buy (or sell short) those stocks.

Answer rating: 100% (QA)

a Using the CAPM equation the riskadjusted required rate of return for each stock can be calculated ... View the full answer