You estimate a regression of the form given by (3.52) below in order to evaluate the effect of various firm-specific factors on the returns of a sample of firms. You run a cross-sectional regression with 200 firms ri = β0 + β1Si + β2MBi + β3PEi + β4BETAi + ui (3.52)

where: ri is the percentage annual return for the stock Si is the size of firm i measured in terms of sales revenue MBi is the market to book ratio of the firm PEi is the price/earnings (P/E) ratio of the firm BETAi is the stock’s CAPM beta coefficient You obtain the following results (with standard errors in parentheses)

ˆri = 0.080 + 0.801Si + 0.321MBi + 0.164PEi − 0.084BETAi

(0.064) (0.147) (0.136) (0.420) (0.120) (3.53)

Calculate the t-ratios. What do you conclude about the effect of each variable on the returns of the security? On the basis of your results, what variables would you consider deleting from the regression? If a stock’s beta increased from 1 to 1.2, what would be the expected effect on the stock’s return? Is the sign on beta as you would have expected? Explain your answers in each case.

AppendixLO1