You have been scouring The Wall Street Journal looking for stocks that are "good values" and have calculated the expected returns for five stocks. Assume the risk-free rate (r,) is 7 percent and the market risk premium (r. - r) is 2 percent. Which security would be the best investment? (Assume you must choose just one.)

Expected Return Beta

a 9.01% 1.70

b. 7.06% 0.00

c  504% -0.67

d  8.74% 087

e11.50% 2.50

Answer:

b. 7.06 %; 0.00

As the CAPM,

Expected return = R_f + Beta x Market Risk Premium

Expected return for option a = 7 + 1.70 x 2 = 10.4 %. But actual return is only 0.01 %

For option b, Expected return is 7 + 0 x 2 = 7 %. But actual return of 7.06 % exceeds the expected return.

For option c, Expected return = 7 - 0.67 x 2 = 5.66 %. But actual return is lower at 5.04 %.

For option d, Expected return = 7 + 0.87 x 2 = 8.74 %. So Actual Return = Expected Return

For option e, Expected return = 7 + 2.5 x 2 = 12 %. Actual return is only 11.50 %

Only the stock at option b gives an actual return which exceeds the expected return. Therefore, it is a good value stock.