CASE STUDY

Mr Fred, a financial analyst for Agricultural 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, 19942003. These data are summarized in the accompanying table. Juniors investigation suggests that both assets, on average, will tend to

Return Data for Assets X and Y, 19942003

Asset X Asset Y

Value Value

Year Cash flow Beginning Ending Cash flow Beginning Ending

1994 $1000 $20000 $22000 $1500 $20000 $20000

1995 1500 22000 21000 1600 20000 20000

1996 1400 21000 24000 1700 20000 21000

1997 1700 24000 22000 1800 21000 21000

1998 1900 22000 23000 1900 21000 22000

1999 1600 23000 26000 2000 22000 23000

2000 1700 26000 25000 2100 23000 23000

2001 2000 25000 24000 2200 23000 24000

2002 2100 24000 27000 2300 24000 25000

2003 2200 27000 30000 2400 25000 25000

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. Fred 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. Applying some sophisticated quantitative techniques, Fred 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%.

Required:

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.

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 19942003.

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.