Assume a major investment service has just given Oasis Electronics its highest investment rating, along with a strong buy recommendation. As a result, you decide to take a look for yourself and to place a value on the company's stock. Here's what you find: This year, Oasis paid its stockholders an annual dividend of $3.66 a share, but because of its high rate of growth in earnings, its dividends are expected to grow at the rate of 12% a year for the next 4 years and then to level out at 8 % a year. So far, you've learned that the stock has a beta of 1.64, the risk-free rate of return is 6%, and the expected return on the market is 11%. Using the CAPM to find the required rate of return, put a value on this stock.

The stock has an expected return of 14.2%.

Explanation:

Capital Asset Pricing Model (CAPM) is what describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security (Corporate Finance Institute, 2015). It is calculated as follows:

Expected Return = Risk free rate + [Beta * (Market rate – risk free rate)]

Re = Rf + [Beta * (Rm - Rf)]

For Oasis, the required rate of return is  

Re = 0.06 + [1.64* (0.11 – 0.06)]

    = 0.142

    = 14.2%

The expected rate of 14.2% is higher than the market rate of 11% and higher than the risk free rate of 6%. The recommendation to buy is supported since it brings the higher return compared to a risk-free investment and the higher than the market rate.  

The stock is undervalued, therefore buy.

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