If the expected market return is 10% and the average risk-free rate is 2%, according to the capital asset pricing model (CAPM) and the security market line (SML), which of the three stocks is most likely undervalued?
Explanation : Calculate the required return for the three stocks and compare them with
the expected return to see which one is undervalued. For XYZ the required
return = 2 + 1.5 x (10 – 2) = 14. XYZ Corp. is undervalued, because it
lies above the SML. The expected return, 16%, is more than the required
return of 14%.