Analyzing Risk and Return on Chargers Products Investments Junior Sayou, a financial analyst for Chargers Products, a manufacturer

of stadium benches, must evaluate the risk and return of two assets, X and Y. The firm is considering adding these assets to its diversified asset portfolio. To assess the return and risk of each asset, Junior gathered data on the annual cash flow and beginning- and end-of year values of each asset over the immediately preceding 10 years, 20002009. Juniors investigation suggests that both assets, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each asset over the past 10 years. Return Data for Assets X and Y, 20002009 Asset X Asset Y Value Value Year Cashflow Beginning Ending Cashflow Beginning Ending 2000 1000 20000 22000 1500 20000 20000 2001 1500 22000 21000 1600 20000 20000 2002 1400 21000 24000 1700 20000 21000 2003 1700 24000 22000 1800 21000 21000 2004 1900 22000 23000 1900 21000 22000 2005 1600 23000 26000 2000 22000 23000 2006 1700 26000 25000 2100 23000 23000 2007 2000 25000 24000 2200 23000 24000 2008 2100 24000 27000 2300 24000 25000 2009 2200 27000 30000 2400 25000 25000 Junior believes that each assets risk can be assessed in two ways: in isolation and as part of the firms diversified portfolio of assets. The risk of the assets in isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital asset pricing model (CAPM) can be used to assess the assets risk as part of the firms portfolio of assets. Applying some sophisticated quantitative techniques, Junior estimated betas for assets X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk-free rate is currently 7% and that the market return is 10%. To Do

a. Calculate the annual rate of return for each asset in each of the 10 preceding years, and use those values to find the average annual return for each asset over the 10-year period.
Asset X Asset Y Value Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Cashflow 1,000 1,500 1,400 1,700 1,900 1,600 1,700 2,000 2,100 2,200 Beginning 20,000 22,000 21,000 24,000 22,000 23,000 26,000 25,000 24,000 27,000 Ending 22,000 21,000 24,000 22,000 23,000 26,000 25,000 24,000 27,000 30,000 Average rate of return Annual rate of return 15.0% =(22,000-20,000+1,000)/20,000 2.3% 21.0% -1.3% 13.2% 20.0% 2.7% 4.0% 21.3% 19.3% 11.7% =total of all returns/10 Cashflow 1,500 1,600 1,700 1,800 1,900 2,000 2,100 2,200 2,300 2,400 Beginning 20,000 20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000 Value Ending 20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000 25,000 Average rate of return Annual rate of return 7.5% 8.0% 13.5% 8.6% 13.8% 13.6% 9.1% 13.9% 13.8% 9.6% 11.1%

b. Use the returns calculated in part a to find (1) the standard deviation and (2) the coefficient of variation of the returns for each asset over the 10-year period 20002009.
Asset X Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Cashflow 1,000 1,500 1,400 1,700 1,900 1,600 1,700 2,000 2,100 2,200 Beginning 20,000 22,000 21,000 24,000 22,000 23,000 26,000 25,000 24,000 27,000 Ending 22,000 21,000 24,000 22,000 23,000 26,000 25,000 24,000 27,000 30,000 X Annual rate of return 15.0% 2.3% 21.0% -1.3% 13.2% 20.0% 2.7% 4.0% 21.3% 19.3% x Expected return 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% 11.7% (X-x) 3.3% =15% - 11.7% -9.5% 9.2% -13.0% 1.4% 8.3% -9.0% -7.7% 9.5% 7.5% Total Standard deviation Coefficient of variation (X-x)2 0.11% 0.90% 0.85% 1.69% 0.02% 0.68% 0.82% 0.60% 0.91% 0.57% 7.13% 8.90% =(7.13%/(10-1)) 0.76 =8.90%/11.7%

Year 2000

Cashflow 1,500

Beginnin g 20,000

Ending 20,000

Asset Y X x Annual rate of return Expected return 7.5% 11.1%

(X-x) -3.6%

(X-x)2 0.13%

2001 2002 2003 2004 2005 2006 2007 2008 2009

1,600 1,700 1,800 1,900 2,000 2,100 2,200 2,300 2,400

20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000

20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000 25,000

8.0% 13.5% 8.6% 13.8% 13.6% 9.1% 13.9% 13.8% 9.6%

11.1% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1%

-3.1% 2.4% -2.6% 2.7% 2.5% -2.0% 2.8% 2.6% -1.5% Total Standard deviation Coefficient of variation

0.10% 0.06% 0.07% 0.07% 0.06% 0.04% 0.08% 0.07% 0.02% 0.70% 2.78% 0.25

c. Use your findings in parts a and b to evaluate and discuss the return and risk associated with each asset. Which asset appears to be preferable? Explain. Asset X Asset Y Return 11.7% 11.1% Risk 8.90% 2.78% Coefficient of variation 0.76 0.25 From the above table, you will observe that Asset X has a higher return over asset y. Similarly the risk, for asset X, is higher. Risk is measured by the standard deviation. The standard deviation measures the variability, of returns, around the expected return. The coefficient of variation measures the possibility that the returns would alternate with the expected return. The above table shows that for both risk measures asset X has a higher risk value. Overall Asset X is more riskier than Asset Y. d. Use the CAPM to find the required return for each asset. Compare this value with the average annual returns calculated in part a.

Under the Capital Asset pricing model (CAPM) asset returns is determined through: Expected returns = Risk-free rate + Beta(Market return Risk-free rate) Expected returns Asset X = Risk-free rate + Beta(Market return Risk-free rate)
Asset X Risk-free rate Market return Beta Expected return (CAPM)

Asset Y 7% 7% 10% 10% 1.6 1.1 10.3% 11.8% =7% + 1.6(10% 7%) From the table, you will notice that asset X has a higher expected return over its expected return. The CAPM return shows that the stock should outperform the expected return. However, Asset Y has a lower expected return when its CAPM returns is compared to the expected annual return. e. Compare and contrast your findings in parts c and d. What recommendations would you give Junior with regard to investing in either of the two assets? Explain to Junior why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each asset.

Beta measures the variability, of returns, with regard to the overall market. The market in this case would be the whole portfolio of assets being traded. Under the Beta rule, assets are expected to have a higher return for an equal amount of risk. Risk is measured by the beta. As beta increases the required return also increases. From the CAPM calculation you will observe that each assets risk is closely matched by its return. This shows that the beta approach accurately measures the investors estimate of risk. However, the standard deviation, of both stocks, is very different whereas both expected returns is only different by a marginal difference. f. Rework parts d and e under each of the following circumstances: (1) A rise of 1% in inflationary expectations causes the risk-free rate to rise to 8% and the market return to rise to 11%. Asset X Asset Y Risk-free rate 8% Market return 11% Beta 1.6 Expected return (CAPM) 12.8%

8% 11% 1.1 11.3%

(2) As a result of favorable political events, investors suddenly become less risk averse, causing the market return to drop by 1%, to 9%. Asset X Asset Y Risk-free rate 7% 7% Market return 9% 9% Beta 1.6 1.1 Expected return (CAPM) 10.2% 9.2%