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.