An investor believes Stock M will rise from a current price of $20 per share to a price of $26 per share over the next year. The company is not expected to pay a dividend. The following information pertains:
　　RF = 8%
　　ERM = 16%
　　Beta = 1.7
　　Should the investor purchase the stock?
　　A. No, because it is undervalued.
　　B. Yes, because it is undervalued.
　　C. Yes, because it is overvalued.
　　D. No, because it is overvalued.
　　Answer:B
　　In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.
　　Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows/dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta * (expected market rate - risk free rate).
　　ER = (26 - 20) / 20 = 0.30 or 30%, RR = 8 + (16 ? 8) × 1.7 = 21.6%. The stock is underpriced therefore purchase.