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Homework answers / question archive / Assume on October 23, 2020, you hold the following in your portfolio with the given expected returns
Assume on October 23, 2020, you hold the following in your portfolio with the given expected returns. Also assume that the expected return on the market is 12% and the risk-free rate is 4%. Security Symbol Expected Return Price P/E Ratio beta $ 1.30 Apple Inc Amgen Inc Amazon.com, Inc AAPL AMGN AMZN 16% 10% 14% 115.04 227.16 3,202.40 34.9 18.6 123.1 0.62 1.35 A. Calculate each stock's risk premium. B. Are any of these stocks a "BUY"? C. Which stock is the “cheapest” on a relative basis?
Answer A)
Risk Premium on stock = Beta *(Expected Return on Market - Risk Free Rate)
Risk Premium on Apple = 1.30*(.12-.04)
Risk Premium on Apple = 1.30*.08
Risk Premium on Apple = 10.4%
Risk Premium on Amgen = .62*(.12-.04)
Risk Premium on Amgen = 4.96%
Risk Premium on Amazon = 1.35*(.12-.04)
Risk Premium on Amazon = 10.8%
Answer B)
Amazon.com,Inc and Apple Inc are stocks worth buying. This is because the expected return on these stocks i.e. 16% and 14% respectively is greater than the expected return on market.
Required Return on Apple = Risk Free rate + Risk Premium calculated in part A
Required Return on Apple = .04 + .104
Required Return on Apple = 14.4%
Required Return on Amazon = Risk Free rate + Risk Premium calculated in part A
Required Return on Amazon = .04+.108
Required Return on Amazon = 14.8%
Both these stocks are plotted above the Security market line and thus should be bought as are considered undervalued stocks.
On the other hand, Amgen,Inc. does not offer higher returns over the market and as a result , does not compensate the investor with sufficient risk for the excess risk related to Amgen,Inc.
Required Return on Amgen = Risk Free rate + Risk Premium calculated in part A
Required Return on Amgen = .04 + .0496
Required Return on Amgen = 8.96%
Amgen is plotted below the SML and is considered overvalued and should not be bought.
Answer C)
The stock which is the cheapest on relative basis is the one with the lowest Price to Earnings ratio.
Hence, Amgen, Inc is the cheapest stock on relative basis with P/E ratio of 18.6.
