Question

You consider buying a share of stock at a price of $25. The stock is expected to pay a dividend of $1.50 next year, and your advisory service tells you that you can expect to sell the stock in 1 year for $28. The stock's beta is 1.1, rf is 6%, and E[rm] = 16%. What is the stock's abnormal return?

A. 1%
B. 2%
C. -1%
D. -2%
E. None of the above

Answer 1

Answer:

A. 1%

Explanation:

Calculation for stock's abnormal return

First step is to find the stock percentage using this formula

Stock=[(Stock in 1 year- Stock price ) + Stock dividend/Stock price ×100]

Let plug in the formula

Stock=[($28 - $25) + $1.50 / $25 ) x 100]

Stock=[($3+$1.50/$25) ×100]

Stock = ($4.50/$25)×100

Stock=0.18×100

Stock =18%

Second step is to find the required return using this formula

Required return =[rf+(E[rm-rf)×Stock's beta]

Let plug in the formula

Required return 6% + (16% - 6%)(1.1)

Required return=6%+10%×1.1

Required return= 16%×1.1

Required return= 0.17×100

Required return= 17%

The last step is to calculation for the abnormal return using the formula

Abormal return =Stock Percentage- Required return percentage

Let plug in the formula

Abormal return=18%-17%

Abormal return=1%

Therefore the stock's abnormal return will be 1%