Analyzing Risk and Return on Chargers Products’ Investments
Junior Sayou, a financial analyst for Chargers Products and 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, 2X06–2X15. 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 for each asset over the past 10 years.
Return Data for Assets X and Y, 2X06 to 2X15
________Asset X____________ ________Asset Y____________
$ Value $ Value
Year Cash Flow Beginning Ending Cash Flow Beginning Ending
2X06 1,000 20,000 22,000 1,500 20,000 20,000
2X07 1,500 22,000 21,000 1,600 20,000 20,000
2X08 1,400 21,000 24,000 1,700 20,000 21,000
2X09 1,700 24,000 22,000 1,800 21,000 21,000
2X10 1,900 22,000 23,000 1,900 21,000 22,000
2X11 1,600 23,000 26,000 2,000 22,000 23,000
2X12 1,700 26,000 25,000 2,100 23,000 23,000
2X13 2,000 25,000 24,000 2,200 23,000 24,000
2X14 2,100 24,000 27,000 2,300 24,000 25,000
2X15 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 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. The capital asset pricing model (CAPM) can be used to assess the 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 is currently 7% and that the market return is 10%.
To Do:
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.
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 2X06–2X15.
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.
Use the CAPM to find the required return for each asset. Compare this value with the average annual returns calculated in part a.
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.