Analyzing Risk and Return on Chargers Products Investments

A Case Study
Maybell Bantay Rhea Bugarin Estephanie Rose Astronomo

CASE BACKGROUND
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. Juniors 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. Junior believes that each assets risk can be assessed in two ways: in isolation and as part of the firms 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 assets risk as part of the firms portfolio of assets. Applying some sophisticated quantitative technique, Junior estimated betas for asset 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%.

DEFINING THE PROBLEM

To evaluate the return and risk associated to asset X and Y. the findings will help Junior to decide whether to add the assets to the companys portfolio. Analyzing Risk and Return on Chargers Products investments | 9

TO DO
a. Calculate the annual rate of return for each asset in each of the 10 preceding years, and use these 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 2000 2009. 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. f. Rework parts d and e under each of the following circumstances 1. A rise of 1% in inflationary expectations causes the risk-free rate to rise to 8% and the market return to rise 11%. 2. As a result of favorable political events, investors suddenly become less risk-averse, causing the market return to drop by 1%, to 9%. 9

Analyzing Risk and Return on Chargers Products investments |

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Cash Flow (Ct) 1,000 1,500 1,400 1,700 1,900 1,600 1,700 2,000 2,100 2,200

Value Beginning Ending (Pt-1) (Pt) 20,000 22,000 22,000 21,000 21,000 24,000 24,000 22,000 22,000 23,000 23,000 26,000 26,000 25,000 25,000 24,000 24,000 27,000 27,000 30,000 TOTAL

Rate of Return (rt) 15.0 2.3 21.0 1.3 13.2 20.0 2.7 4.0 21.3 19.3 117.5

COMPUTATIONS

Rate of Return for Assets X and Y in each of the 10 preceding years

ASSET X

Analyzing Risk and Return on Chargers Products investments |

ASSET Y

Average Annual Return for Assets X and Y

ASSET X n = 117.5 10 = 11.8 ASSET Y n = 111.4 10 = 11.1

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Cash Flow (Ct) 1,500 1,600 1,700 1,800 1,900 2,000 2,100 2,200 2,300 2,400

Value Beginning (Pt-1) 20,000 20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000

Ending (Pt) 20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000 25,000 TOTAL

Rate of Return (rt) 7.5 8.0 13.5 8.6 13.8 13.6 9.1 13.9 13.8 9.6 111.4 9

Standard Deviation
ASSET X Analyzing Risk and Return on Chargers Products investments |

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Return on Asset r 15.0 2.3 21.0 1.3 13.2 20.0 2.7 4.0 21.3 19.3

Expected Value of Return r 11.74 11.74 11.74 11.74 11.74 11.74 11.74 11.74 11.74 11.74

rr 3.26 -9.46 9.22 -12.99 1.45 8.26 -9.04 -7.74 9.51 7.52 TOTAL

(r r)2 10.65 89.55 84.94 168.63 2.09 68.30 81.79 59.84 90.52 56.60 712.92

= = = =

((r r)2) n 1 2.92. (10 1) 8.9

ASSET Y Return on Asset r 7.5 8.0 13.5 8.6 13.8 13.6 9.1 13.9 13.8 9.6 Expected Value of Return r 11.14 11.14 11.14 11.14 11.14 11.14 11.14 11.14 11.14 11.14

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

rr -3.64 -3.14 2.36 -2.54 2.66 2.46 -2.04 2.76 2.66 -1.54 TOTAL

(r r)2 13.2 9.9 5.6 6.5 7.1 6.1 4.2 7.6 7.1 2.4 69.55

= = = =

((r r)2) n 1 .55 (10 1) 2.8 9

Analyzing Risk and Return on Chargers Products investments |

Coefficient of Variation
ASSET X CV = r r = 8.9_ 11.74 = 0.8 ASSET Y CV = r r = 2.78_ 11.14 = 0.2

Capital Asset Pricing Model (CAPM)

ASSET X Return on Asset = Rf + [b x (rm Rf)] = 7 + [1.60 x (10 7)] = 11.8 ASSET Y Return on Asset = Rf + [b x (rm Rf)] = 7 + [1.10 x (10 7)] = 10.3

Changes in Inflationary Expectations A rise of 1% in inflationary expectations ASSET X Return on Asset = Rf + [b x (rm Rf)] = 8 + [1.60 x (11 8)] = 12.8 ASSET Y Analyzing Risk and Return on Chargers Products investments |

Return on Asset = Rf + [b x (rm Rf)] = 8 + [1.10 x (11 8)] = 11.3 Asset X Average Annual Return (r) Standard Deviation (r) Coefficient of Variation (CV) Beta Required Return for Asset Changes in Inflationary Expectations (A rise of 1% in inflationary expectations) Changes in Risk Aversion (Market return to drop by 1%) 11.8 8.9 0.8 1.60 11.8 12.8 10.2 Asset Y 11.1 2.8 0.2 1.10 10.3 11.3 9.2

Changes in Risk Aversion Market return to drop by 1% ASSET X Return on Asset = Rf + [b x (rm Rf)] = 7 + [1.60 x (9 7)] = 10.2 ASSET Y Return on Asset = Rf + [b x (rm Rf)] = 7 + [1.10 x (9 7)] = 9.2

ANALYSIS

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. The standard deviation and the coefficient of variation at both

higher for asset X. While the average annual return for both assets is almost the same, asset X is riskier compared to asset Y. This clearly shows that it is be preferable to invest in asset Y. Analyzing Risk and Return on Chargers Products investments |

Use the CAPM to find the required return for each asset. Compare this value with the average annual returns calculated in part a. While the average annual return and the required return

(calculated using CAPM) for asset X is the same, 11.8%, the average annual return for asset Y exceeded the required return (calculated using CAPM) by 0.8% (11.1 10.3).

RECOMMENDATION
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. After computing the standard deviation, coefficient of variation and the required return for an asset using the CAPM, the verdict is quite unanimous. Asset X is higher in both standard deviation and coefficient of variation. Also, asset X has a higher beta, which means that it is more responsive to the market and thus, makes it more risky. If Junior wants to know which asset is riskier, using the standard deviation and the coefficient of variation is enough. But it is better to use beta in evaluating two or more assets. Standard deviation and coefficient of variation only show which asset is riskier. The beta, meanwhile, aside from showing which asset is less risky, it also shows 9

Analyzing Risk and Return on Chargers Products investments |

the expected return of an asset. This will enable you to evaluate the assets better. Using the beta has shown us that it is preferable to invest in asset Y, not only because it is less risky, but also because its annual return exceeded its expected return.

Analyzing Risk and Return on Chargers Products investments |