You are analyzing a stock that has a beta of 1.20. The risk-free rate is 5.0 % and you estimate the market risk premium to be 6.0 %. If you expect the stock to have a return of 11.0 % over the next year, should you buy it? Why or why not?

No, you should not buy the it, Rate of 11% does not fully compensate your risk associated with the Beta 1.2. On this beta you should expect 12.2% return. Any other stock with lower risk might be acceptable for 11% return.

Explanation:

Capital asset pricing model measure the expected return on an asset or investment. it is used to make decision for addition of specific investment in a well diversified portfolio.

Formula for CAPM

Expected return = Risk free rate + beta ( market risk premium )

Expected return = 5% + 1.2 ( 6% )

Expected return = 5% + 7.2%

Expected return = 12.2%

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