Case Analysis in BA 142

ANALYSING RISK AND RETURN ON CHARGERS PRODUCTS INVESTMENTS

Chua, Francis Czeasar M.

Virata School of Business, University of the Philippines Diliman 10 December 2013

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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, 1994 2003. 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%.

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A. Annual Rates of Return and Expected Rates of Return

ASSET X MVENDING 22,000 21,000 24,000 22,000 23,000 26,000 25,000 24,000 27,000 30,000

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

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

MVBEGINNING 20,000 22,000 21,000 24,000 22,000 23,000 26,000 25,000 24,000 27,000

MV 2,000 -1,000 3,000 -2,000 1,000 3,000 -1,000 -1,000 3,000 3,000 SUM

Rate of Return (%) 15.00 2.27 20.95 -1.25 13.18 20.00 2.69 4.00 21.25 19.26 117.36 11.74

AVERAGE RATE OF RETURN ASSET Y MVENDING 20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000 25,000

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

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

MVBEGINNING 20,000 20,000 20,000 21,000 21,000 22,000 23,000 23,000 24,000 25,000

MV 0 0 1,000 0 1,000 1,000 0 1,000 1,000 0 SUM

Rate of Return (%) 7.50 8.00 13.50 8.57 13.81 13.64 9.13 13.91 13.75 9.60 111.41 11.14

AVERAGE RATE OF RETURN

Formulae used: Cash Flow + MV MVBEGINNING

Annual Rate of Return =

Average Rate of Return =

2003 1994 Annual Rate of Return 10

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B. Standard Deviation and Coefficients of Variation

ASSET X Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Rate of Return (rj) 15.00 2.27 20.95 -1.25 13.18 20.00 2.69 4.00 21.25 19.26 Average Rate of Return ( ) 11.74 11.74 11.74 11.74 11.74 11.74 11.74 11.74 11.74 11.74 SUM STANDARD DEVIATION OF RETURNS (%), ASSET X COEFFICIENT OF VARIATION OF RETURNS ASSET Y Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Annual Rate of Return (rj) 7.50 8.00 13.50 8.57 13.81 13.64 9.13 13.91 13.75 9.60 Average Rate of Return ( ) 11.14 11.14 11.14 11.14 11.14 11.14 11.14 11.14 11.14 11.14 SUM STANDARD DEVIATION OF RETURNS (%), ASSET Y COEFFICIENT OF VARIATION OF RETURNS (rj - )2 13.26 9.87 5.56 6.60 7.12 6.23 4.04 7.68 6.81 2.37 69.55 2.78 0.25 (rj - )2 10.65 89.55 84.94 168.63 2.09 68.30 81.79 59.84 90.52 56.60 712.92 8.90 0.76

Formulae used: ASSET

2 2003 1994 (rj ) = 10 1

Coefficient of Variation =

ASSET

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C. Discussion: Risk and Return

As observed by the values obtained in the previous sections, it could be said that in terms of return, Asset X yields a slightly higher rate. However, Asset Y is less risky on both measures of absolute risk (standard deviation) and relative risk (coefficient of variation). At this point, Asset Y appears to be more preferable as the difference in the rates of return is small while it poses a significantly lower risk.

D. Capital Asset Pricing Model (CAPM)

CAPM Market Return (%), rm 10 10

Asset X Y

Beta, bj

1.60 1.10

Risk-free Return (%), RF 7 7

Required Rate of Return (%), rj 11.80 10.30

SML:

Security Market Line

14.00 12.00 10.00 8.00RF 6.00 4.00 2.00 0.00 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80

rX rm rY

Formula used: = + [ ( )]

*When compared to the rates of return obtained using averaging, it is observed that the rates for Asset X are almost the same while that of Asset Y is lower when CAPM is used. Thus, while the rates for Asset X are virtually the same, the average annual rate (the expected rate of return) for Asset Y exceeded the required rate of return given the present market conditions. With these observations and with the fact that Asset Y is less risky, given the betas, it is safe to assert that Asset Y is still the more preferable asset.

Chua |6 E. Recommendations

For the reasons previously expounded, J. Sayou is advised to pick Asset Y to form part of the companys portfolio. As regards the more appropriate method for the assessment of investment viability, the CAPM would be more reliable as the company intends to measure such asset that would yield high return and low risk as part of a portfolio and as it was briefed, the CAPM is the measure for such assessment. Furthermore, CAPM takes only into account the nondiversifiable risk associated with an asset in a portfolio which is generally buffered when simple methods of averaging and measures of variability are used.

F. Modifications Due to Changes in Market Conditions

F.1. Rise in Inflationary Expectations
14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 0.00 0.50 1.00 1.50 2.00

rX rm rY

RF

SML 1 SML 2

Asset X Y

Beta (bj)

1.60 1.10

Risk-free Return (%), RF 8 8

CAPM Market Return (%), rm 11 11

Required Rate of Return (%), rj 12.80 11.30

*Given the rise of inflationary expectations, both of the expected returns fall short of the required rates of return. Asset Y will still be preferable as it is less risky. It will, however, ultimately depend on the risk preference of J. Sayou whether or not the additional risk of choosing Asset X would be acceptable for the slight increase on expected return.

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F.2. Decrease in Risk Aversion of Investors

14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 0.00 0.50 1.00 1.50 2.00

rX rm rY

RF

SML 1 SML 3

Asset X Y

Beta (bj)

1.60 1.10

Risk-free Return (%), RF 7 7

CAPM Market Return (%), rm 9 9

Required Rate of Return (%), rj 10.20 9.20

*If such decrease in investors risk aversion would happen, it will be wise to choose Asset Y as it is less riskyboth of the expected returns of the assets would exceed the required returns. Again, Asset Y would be slightly lower in terms of return but would be significantly less risky in terms of absolute, relative and nondiversifiable risks.