Chartered Financial Analyst Level 1
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An investor evaluates the following data for three stocks: Stock | Expected Rate of Return | Investor's Required Rate of Return 1 | 9% | 9% 2 | 13% | 11% 3 | 15% | 16% Assuming all other factors are equal, which stock should the investor purchase?
Explanation:
Explanation:
Option A (Stock 1): Incorrect. The expected rate of return for Stock 1 matches the investor's required rate of return (9%). If the expected return does not exceed the required return, investors may seek better opportunities elsewhere, leading to a potential decline in the stock's price.
Option B (Stock 2): Correct. The expected rate of return for Stock 2 (13%) exceeds the investor's required rate of return (11%). This indicates that the stock offers a higher return than the minimum demanded by investors, making it an attractive investment. The cost of equity must meet or exceed investors' required returns to maintain or increase the stock's price in the secondary market.
Option C (Stock 3): Incorrect. The expected rate of return for Stock 3 (15%) is below the investor's required rate of return (16%). If the expected return is insufficient, investors may sell their shares, causing the stock price to decline.
In summary, Stock 2 is the optimal choice as it provides a return above the investor's required threshold, aligning with the principles of equity valuation.