Question 2

You plan to invest part of your savings and are examining the following data:

	Expected Return	Beta
Yield to maturity on 10-year government bonds	2%
Stock A	20%	1.3
Stock B	9%	1.1
Stock C	7%	0.5
Portfolio D	10%	1.0

(a) If only Portfolio D is correctly priced, are stocks A, B and C correctly priced? If not, what investment action would you recommend for each stock to take advantage of the price anomaly? (10 marks)

(b) Company X has just paid a dividend of $0.20 per share. The company expects dividends to grow at 5% per annum for the foreseeable future. It is trading at $10 in the market. You feel that, given the risk of this company, your required return on this stock is 8%. Is the market assigning a lower or higher risk to this stock compared to its fair value? Appraise this observation in relation to the SML .