Question 1

Bernice Williams and Marcia Cooper are young Investment Analysts in a reputable investment firm. They are approached by Delroy Brown, a potential investor, who wants to invest in the securities market. He has limited knowledge of how the securities market work, but a friend told him about securities that are undervalued and overvalued. Both Bernice and Marcia explained to him that the valuation of securities is based on the present value of the future cash flow. They went on to show him an example of how to identify overvalued, undervalued or properly valued securities. They used the Capital Assets Pricing Model (CAPM) to illustrate this concept.

The risk-free rate of return is 10% and the market rate of return is 14%.

Stock Beta

X 0.85

Y 1.25

Z -0.20

A. Compute the required rate of return for Stock X, Y and Z. (9 marks)

You ask a stockbroker what the firms research department expects for the three stocks above, that is, Stock X, Y, and Z. The broker responds with the following information:

Stock	Current Price	Expected Price	Expected Divided
X	22	24	0.74
Y	48	51	2.00
Z	37	40	1.25

B. Calculate the estimated future rate of return for Stock X, Y, and Z. (9 marks)

C. Determine which stock is overvalued, undervalued, properly valued, and state why. (2 marks) (Total 20 marks)