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Ch 03-14 Build a Model 10/21/2001

Chapter 3. Ch 03 P14 Build a Model

a. Use the data given to calculate annual returns for Bartman, Reynolds, and the Market Index, and then
calculate average returns over the five-year period. (Hint: Remember, returns are calculated by subtracting the
beginning price from the ending price to get the capital gain or loss, adding the dividend to the capital gain or
loss, and dividing the result by the beginning price. Assume that dividends are already included in the index.
Also, you cannot calculate the rate of return for 1997 because you do not have 1996 data.)

Data as given in the problem are shown below:


Bartman Industries Reynolds Incorporated Market Index
Year Stock Price Dividend Stock Price Dividend Includes Divs.
2002 $17.250 $1.150 $48.750 $3.000 11,663.98
2001 14.750 1.060 52.300 2.900 8,785.70
2000 16.500 1.000 48.750 2.750 8,679.98
1999 10.750 0.950 57.250 2.500 6,434.03
1998 11.375 0.900 60.000 2.250 5,602.28
1997 7.625 0.850 55.750 2.000 4,705.97

We now calculate the rates of return for the two companies and the index:

Bartman Reynolds Index


2002
2001
2000
1999
1998

Average

Note: To get the average, you could get the column sum and divide by 5, but you could also use the function wizard,
fx. Click fx, then statistical, then Average, and then use the mouse to select the proper range. Do this for Bartman
and then copy the cell for the other items.

b. Calculate the standard deviation of the returns for Bartman, Reynolds, and the Market Index. (Hint: Use the
sample standard deviation formula given in the chapter, which corresponds to the STDEV function in Excel.)

Use the function wizard to calculate the standard deviations.

Bartman Reynolds Index


Standard deviation of returns

c. Now calculate the coefficients of variation Bartman, Reynolds, and the Market Index.

Bartman Reynolds Index


Coefficient of Variation

d. Construct a scatter diagram graph that shows Bartmans and Reynolds returns on the vertical axis and the
market indexs returns on the horizontal axis.

It is easiest to make scatter diagrams with a data set that has the X-axis variable in the left column, so we
reformat the returns data calculated above and show it just below.

Year Index Bartman Reynolds


2002 0.0% 0.0% 0.0%
2001 0.0% 0.0% 0.0%
2000 0.0% 0.0% 0.0%
1999 0.0% 0.0% 0.0%
1998 0.0% 0.0% 0.0%

To make the graph, we first selected the range with the returns and the column heads, then clicked the chart wizard,
then choose the scatter diagram without connected lines. That gave us the data points. We then used the drawing
toolbar to make free-hand ("by eye") regression lines, and changed the lines color and weights to match the dots.

e. Estimate Bartmans and Reynolds betas by running regressions of their returns against the Market Index's
returns. Are these betas consistent with your graph?

We can use the data just above the graph to do the regression. Look at the explanation of how to do regressions in the model
for this chapter (Ch 03 Tool Kit.xls) if need be. But to summarize, click on Tools, Data Analysis, Regression and then follow the menu.
We first calculate Bartman's beta, then Reynolds'.

Bartman's Calculations.
SUMMARY OUTPUT Bartman's beta =
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations

ANOVA
df SS MS F Significance F
Regression
Residual
Total

Coefficients Standard Error t Stat P-value Lower 95%


Intercept
X Variable 1

RESIDUAL OUTPUT

Observation Predicted Y Residuals


1
2
3
4
5

Reynolds' Calculations

SUMMARY OUTPUT

Regression Statistics
Multiple R
R Square Reynolds' beta =
Adjusted R Square
Standard Error
Observations

ANOVA
df SS MS F Significance F
Regression
Residual
Total

Coefficients Standard Error t Stat P-value Lower 95%


Intercept
X Variable 1
RESIDUAL OUTPUT

Observation Predicted Y Residuals


1
2
3
4
5

f. The risk-free rate on long-term Treasury bonds is 6.04%. Assume that the market risk premium is 5%.
What is the expected return on the market? Now use the SML equation to calculate the two companies required returns.

Market risk premium (RPM)= 5.000%


Risk-free rate = 6.040%

Expected return on market = Risk-free rate + Market risk premium


= 6.040% + 5.000%
= 11.040%

Required return

Bartman:
Required return =
=

Reynolds:
Required return =
=

g. If you formed a portfolio that consisted of 50% Bartman and 50% Reynolds, what would be its beta and its
required return?

The beta of a portfolio is simply a weighted average of the betas of the stocks in the portfolio, so this portfolio's beta
would be:

Portfolio beta =

h. Suppose an investor wants to include Bartman Industries stock in his or her portfolio. Stocks A, B, and C are
currently in the portfolio, and their betas are 0.769, 0.985, and 1.423, respectively. Calculate the new portfolios
required return if it consists of 25 percent of Bartman, 15 percent of Stock A, 40 percent of Stock B, and 20
percent of Stock C.
Beta Portfolio Weight
Bartman 25%
Stock A 0.769 15%
Stock B 0.985 40%
Stock C 1.423 20%
100%
Portfolio Beta = 0.794

Required return on portfolio: = Risk-free rate + Market Risk Premium * Beta


=
=
the model
hen follow the menu.
cance F

Upper 95%

cance F

Upper 95%
equired returns.