analyzing rick and return
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 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, 2000–2009. 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, 2000–2009
Asset X Asset Y
Year Cash flow Beginning Ending Cash flow Beginning Ending
2000 $1,000 $20,000 $22,000 $1,500 $20,000 $20,000
2001 1,500 22,000 21,000 1,600 20,000 20,000
2002 1,400 21,000 24,000 1,700 20,000 21,000
2003 1,700 24,000 22,000 1,800 21,000 21,000
2004 1,900 22,000 23,000 1,900 21,000 22,000
2005 1,600 23,000 26,000 2,000 22,000 23,000
2006 1,700 26,000 25,000 2,100 23,000 23,000
2007 2,000 25,000 24,000 2,200 23,000 24,000
2008 2,100 24,000 27,000 2,300 24,000 25,000
2009 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%.
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
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 returns 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