A fund manager gathers the following data in order to assess a stock’s potential for a possible addition to her portfolio: Company’s net income = $20 million Company’s equity at the beginning of the year = $140 million Company’s weighted average cost of capital (WACC) = 10.75% Stock’s beta = 1.80 Market risk premium = 5.25% Risk-free rate = 3.50% Fund manager’s required rate of return = 13.60% Which of the following is the most appropriate decision for the fund manager? A. Do not invest in the stock. B. Invest in the stock because the company’s ROE is greater than the required rate of return. C. Invest in the stock because the required rate of return is greater than the company’s WACC The answer is A, I dont understand what they are trying to say in the answer, can anyone rephrase the answer, thank you in advance.
The fund manager expects 13.6% return, whereas according to CAPM the stock will give only 12.95%, so ideally the fund manager should not invest in the stock.
While this could be the logic, I doubt whether it makes real sense, as fund manager cannot expect a return that is greater than CAPM (all investors have same expectation). Even if it a portfolio’s expectation the fund manager need to evaluate the return in tandem with risk and correlation.
The CAPM return is the required return, right? So if the required return is less than the expected return, then why would he not invest? What am I missing here?