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COR.

CORPORATE FINANCE AND INVESTMENT

CASE STUDY -

Joey Moss, a recent finance graduate, has just begun his

job with the investment firm of Covili and Wyatt. Paul

Covili, one of the firm's founders, has been talking to

Joey about the firm's investment portfolio.

As with any investment, Paul is concerned about the

risk of the investment as well as the potential return. More

specifically, because the company holds a diversified

portfolio, Paul is concerned about the systematic risk of

current and potential investments. One such position the

company currently holds is stock in Colgate-Palmolive

(CL). Colgate-Palmolive is the well-known manufacturer

of consumer products under brand names such as Colgate,

Palmolive, Softsoap, Irish Spring, Ajax, and others.

Covili and Wyatt currently uses a commercial data

vendor for information about its positions. Because of

this, Paul is unsure exactly how the numbers provided are

calculated. The data provider considers its methods

proprietary, and it will not disclose how stock betas and

other information are calculated. Paul is uncomfortable

with not knowing exactly how these numbers are being

computed and also believes that it could be less expensive

to calculate the necessary statistics in-house. To explore

this question, Paul has asked Joey to do the following

assignments.

QUESTIONS

Go to finance.yahoo.com and download the ending

monthly stock prices for Colgate-Palmolive for the last 60

months. Use the adjusted closing price, which adjusts for

dividend payments and stock splits. Next, download the

ending value of the S&P 500 Index over the same period.

For the historical risk-free rate, go to the St. Louis

Federal Reserve website (www.stlouisfed.org) and find the

three-month Treasury bill secondary market rate. Download

this file. What are the monthly returns, average monthly

returns, and standard deviations for Colgate-Palmolive

stock, the three-month Treasury bill, and the S&P 500 for

this period?

2. Beta is often estimated by linear regression. A model

commonly used is called the market model, which is:

R, - Ra = 0; + Bi[RMI - RAl+&

In this regression, R, is the return on the stock and Rn is the

risk-free rate for the same period. Ru is the return on a

stock market index, such as the S&P 500 index; a is the

regression intercept; B is the slope and the stock's

estimated beta); and & represents the residuals for the

regression. What do you think is the motivation for this

particular

regression? The

intercept,

d,

is often

called Jensen's alpha. What does it measure? If an asset has

a positive Jensen's alpha, where would it plot with respect

to the SML? What is the financial interpretation of the

residuals in the regression?