A Canadian Pension Plan (CPP) investment committee uses the Capital Asset Pricing Model (CAPM) to evaluate potential equity investments. An analyst presents an investment opportunity with an expected return of 12%, a beta of 1.4, given the current risk-free rate of 3% and an expected market risk premium of 6%. Based on the CAPM, what recommendation should the committee consider for this investment?

Question: A Canadian Pension Plan (CPP) investment committee uses the Capital Asset Pricing Model (CAPM) to evaluate potential equity investments. An analyst presents an investment opportunity with an expected return of 12%, a beta of 1.4, given the current risk-free rate of 3% and an expected market risk premium of 6%. Based on the CAPM, what recommendation should the committee consider for this investment?

Answer options: ✅ The investment is undervalued and should be purchased.

• The investment is overvalued and should not be purchased.
• The investment is fairly valued, and a decision requires other factors.
• The investment has a lower systematic risk than the market, making it attractive.

Correct answer: The investment is undervalued and should be purchased.

Explanation: The CAPM required return is Risk-Free Rate + Beta * (Market Risk Premium). Here, Required Return = 3% + 1.4 * 6% = 3% + 8.4% = 11.4%. Since the expected return (12%) is greater than the required return (11.4%), the investment is considered undervalued and potentially a good purchase.