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 the 1 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, 2003-2012. These data are summarized in the table below. Junior's 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 of: each asset over the past 10 years. 

 

 

 

Return Data for Assets X and Y, 2003-2012 

 

                                                              Asset X                                                                  Asset Y 

                                                                          Value                                                                   Value 

  Year 

 Cash flow 

 Beginning 

 Ending 

 Cash flow 

 Beginning 

 Ending 

   2003  

       $1,000            

    $20,000           

 $22,000  

         $1,500             

       $20,000      

 $20,000   

   2004 

 1,500 

 22,000 

 21,000 

 1,600 

 20,000 

 20,000 

   2005 

 1,400 

 21,000 

 24,000 

 1,700 

 20,000 

 21,000 

   2006 

 1,700 

 24,000 

 22,000 

 1,800 

 21,000 

 21,000 

   2007 

 1,900 

 22,000 

 23,000 

 1,900 

 21,000 

 22,000 

   2008 

 1,600 

 23,000 

 26,000 

 2,000 

 22,000 

 23,000 

   2009 

 1,700 

 26,000 

 25,000 

 2,100 

 23,000 

 23,000 

   2010 

 2,000 

 25,000 

 24,000 

 2,200 

 23,000 

 24,000 

   2011 

 2,100 

 24,000 

 27,000 

 2,300 

 24,000 

 25,000 

   2012 

 2,200 

 27,000 

 30,000 

 2,400 

 25,000 

 25,000 

   

Junior believes that each asset's risk can be assessed in two ways: in isolation and as part of the firm's diverse 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 asset's risk as part of the firm's 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 currently 7.0% and that the market return is 10.0%. 

 

 

 

Page 1 

 

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 out 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 2003-2012. 

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. 

d.     Use the CAPM to find the required return for each asset. Compare this value with the average annual return calculated in part (a). 

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. 

f.       Rework parts (d) and (e) under each of the following circumstances: 

(1) A rise of 1.0% in inflationary expectations causes the risk-free rate to rise to 8.0% and the market return rise to 11.0%. 

(2) As a result of favorable political events, investors suddenly become less risk-averse, causing the market to drop by 1.0%, to 9.0%.