Question:
Ryan, a financial analyst for DMC Products, a manufacturer of school 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, Ryan gathered data on the annual cash flow and beginning- and end-of-year values of each asset over the immediately pre- ceding 10 years, 1994-2003. These data are summarized in the accompanying table. Ryan'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, 1994-2003
|
Year
|
|
Asset X
|
|
|
Asset Y
|
|
|
Cash flow
|
|
Value
|
Cash flow
|
|
Value
|
|
Beginning
|
Ending
|
Beginning
|
Ending
|
|
1994
|
$1,000
|
$20,000
|
$22,000
|
$ 1,500
|
$20,000
|
$20,000
|
|
1995
|
1,500
|
1/,000
|
21,000
|
1,600
|
20,000
|
20,000
|
|
1996
|
1,400
|
21,000
|
24,000
|
1,700
|
20,000
|
21,000
|
|
1997
|
1.700
|
24,000
|
22,000
|
1,800
|
21,000
|
21,000
|
|
1998
|
1,900
|
22,000
|
23,000
|
1,900
|
21,000
|
22,000
|
|
1999
|
1,600
|
13,000
|
26,000
|
2,000
|
22,000
|
23,000
|
|
2000
|
1,700
|
26,000
|
25,000
|
2,100
|
23,000
|
23,000
|
|
2001
|
2,000
|
25,000
|
24,000
|
2,200
|
23,000
|
24,000
|
|
2002
|
2,100
|
24,000
|
27,000
|
2,300
|
24,000
|
25,000
|
|
2003
|
2,200
|
27,000
|
30,000
|
2,400
|
25,000
|
25,000
|
Ryan 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 varia- tion 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, he 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 period 1994-2003.
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 Ryan with regard to investing in either of the two assets? Explain to Ryan why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each asset.