The Return and Risk of Each Asset for Chargers Products - Assignment Example

Assignment extract: 1 HC2091 BUSINESS FINANCE GROUP ASSIGNMENT Trimester 2, 2006 Length : 1,500 words Assessment Value : 20% of total marks Stanley, 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, Stanley gathered data on the annual cash flow and beginning-and end-of-year values of each asset over the immediately proceeding ten years. 1995-2004. These data are summarised in the following table. Stanley's investigation suggests that both assets, on average, will tend to perform in the future just as they have during the past ten years. He, therefore, believes that the expected annual return can be estimated by finding the average annual return for each asset over the past ten years. Stanley 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 ten 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 (ß) 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 the market return is 10%. 2 Return data for assets X and Y, 1995-2004 ASSET X Year Cash Flow ($) Beginning Value ($) Ending Value ($) 1995 1,000 20,000 22,000 1996 1,500 22,000 21,000 1997 1,400 21,000 24,000 1998 1,700 24,000 22,000 1999 1,900 22,000 23,000 2000 1,600 23,000 26,000 2001 1,700 26,000 25,000 2002 2,000 25,000 24,000 2003 2,100 24,000 27,000 2004 2,200 27,000 30,000 ASSET Y Year Cash Flow ($) Beginning Value ($) Ending Value ($) 1995 1,500 20,000 20,000 1996 1,600 20,000 20,000 1997 1,700 20,000 21,000 1998 1,800 21,000 21,000 1999 1,900 21,000 22,000 2000 2,000 23,000 23,000 2001 2,100 23,000 23,000 2002 2,200 23,000 24,000 2003 2,300 24,000 25,000 2004 2,400 25,000 25,000 REQUIRED a. Calculate the annual rate of return for each asset in each of the ten preceding years, and use those values to find the average annual return for each asset over the ten-year period. (4 marks) ASSET X ASSET Y b. The standard deviation and the coefficient of variation of the returns for each asset over the ten-year period is as follows: Standard Deviation Coefficient of Variation Asset X 8.90% 0.76 Asset Y 2.78% 0.25 Using standard deviation and coefficient of variation and your findings in a, evaluate and discuss the return and risk associated with each asset. Which asset appears to be preferable? Explain. (2 marks) The standard deviation of Asset X is 8.9% and the expected return is 11.74, where as the standard deviation of Asset Y is 2.78% with an expected return of 10.65. Coefficient of Variation is defined as the risk (Standard Deviation) of a security per unit return. Since the Coefficient of Variation of asset X is higher than the coefficient of variation of asset Y therefore the risk per unit return of asset X is higher. Most investors are risk averse and thus would tend to avoid taking a higher risk for a given level of return. This Asset Y seems more preferable. c. Use the CAPM to find the required return for each asset. Compare this value with the average annual returns calculated in a. (2 marks) Risk Free rate = 7% Market return = 10% βX = 1.60 βY = 1.10 According to CAPM Req. Rate (k) = Risk Free rate (kRF)+ (Market return (kM) – Risk Free rate (kRF)) β kX = kRF+ (kM –kRF) βX kX = 7 + (10 – 7)1.60 kX = 11.8 kY = kRF+ (kM –kRF) βY kY = 7 + (10 – 7) 1.10 kY = 10.3 d. Compare and contrast your findings in c and d. What recommendations would you give Stanley with regard to investing in either of the two assets? Explain to Stanley why he is better off using beta rather than the standard deviation and co-efficient of variation to assess the risk of each asset. (2 marks) (In this question I believe we have to contrast answers in b and c) Asset X and Y when compared individually we consider standard deviations. This is because we are investing in only one asset and are mainly concerned with the return on the asset. We do not in this case diversify the risk. On this basis Asset Y is preferable. When investing in a portfolio of assets we effectively diversify the diversifiable risk. Thus we are interested in the market risk of the security or the beta. The required return from Asset X is 11.8 whereas the expected return is 11.74. Therefore it is not advisable to invest into this asset. The required rate of return from Asset Y is 10.3 and the expected return is 10.65. Since the expected return is higher than required return it is advisable to invest into this asset. e. Rework c and d 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 to 11%. (2 marks) kX = kRF+ (kM –kRF) βX kX = 8 + (11 – 8)1.60 kX = 12.8 kY = kRF+ (kM –kRF) βY kY = 8 + (11 – 8) 1.10 kY = 11.3 (2) As a result of favourable political events, investors suddenly become less risk-averse, causing the market return to drop by 1 to 9%. (2 marks) kX = kRF+ (kM –kRF) βX kX = 7 + (9 – 7)1.60 kX = 11.2 kY = kRF+ (kM –kRF) βY kY = 7 + (2 – 7) 1.10 kY = 9.2 (3) Evaluate discuss the implications of changes in market return on asset returns. (2 marks) f. Explain the relationship between total risk, non-diversifiable risk and diversifiable risk. Why would someone argue that non-diversifiable risk is the only relevant risk. (2 marks) Total is risk the sum of the non diversifiable risk and the diversifiable risk on a security. The diversifiable risk is the risk associated with a specific security and can be diversified (eliminated) by diversifying the portfolio. Non diversifiable risk is that risk which cannot be removed; it is the market risk or the systematic risk of the security. Thus non diversifiable risk is the only relevant risk. Another factor regarding non diversifiable risk is that return is only for the non diversifiable risk and not the diversifiable since investors are expected to diversify diversifiable risk. g. What risk is measured by beta. Define beta. How are asset betas derived and where can they be obtained? How can you find the beta of a portfolio? (2 marks) Beta measures non diversifiable or market risk. Beta is the sensitivity of the security with the market. Beta can be calculated using: A fully diversified portfolio will have a beta of 1. Otherwise beta for a portfolio will be: 4 Guidelines for the assignment Assignments should be typed using font 12 Times New Roman or Ariel. Clarity and succinctness of expression is encouraged. A professional presentation is expected. No marks will be allocated for irrelevant material. Use the attached 'assignment cover sheet" for submission. Please do not submit in plastic pockets or any other form of folder. Your are required to (1) retain a soft copy of the assignment; (2) submit the hard copy on the due date to Student Administration on ground floor; and (3) e-mail the soft copy to the Blackboard on the due date. 5 ASSIGNMENT COVER SHEET Subject HC2091 BUSINESS FINANCE Lecturer Title of Assignment HC2091 Group Assignment Due Date 26 October 2006 Date of Submission …………………………….. We certify that: · This assignment is our work. · We acknowledged and disclosed fully any assistance received in its preparation. · Cited any sources from which we used data, ideas, words, either quoted directly or paraphrased. · This assignment was prepared by us specifically for this subject. · Members of the syndicate made equal contribution. 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