Chapter 6.

Ch 06 P14 Build a Model

a. Use the data given to calculate annual returns for Bartman, Reynolds, and the Market Index, and then calculate average returns over the five-year period. (Hint: Remember, returns are calculated by subtracting the beginning price from the ending price to get the capital gain or loss, adding the dividend to the capital gain or loss, and dividing the result by the beginning price. Assume that dividends are already included in the index. Also, you cannot calculate the rate of return for 2005 because you do not have 2004 data.) Data as given in the problem are shown below: Bartman Industries Year Stock Price Dividend 2010 $17.250 $1.150 2009 14.750 1.060 2008 16.500 1.000 2007 10.750 0.950 2006 11.375 0.900 2005 7.625 0.850

Reynolds Incorporated Stock Price $48.750 52.300 48.750 57.250 60.000 55.750

Market Index Dividend Includes Divs. $3.000 11,663.98 2.900 8,785.70 2.750 8,679.98 2.500 6,434.03 2.250 5,602.28 2.000 4,705.97

We now calculate the rates of return for the two companies and the index: Bartman 24.7% -4.2% 62.8% 2.9% 61.0% 29.4% Reynolds -1.1% 13.2% -10.0% -0.4% 11.7% 2.7% Index 32.8% 1.2% 34.9% 14.8% 19.0% 20.6%

2010 2009 2008 2007 2006 Average

Note: To get the average, you could get the column sum and divide by 5, but you could also use the function wizard, fx. Click fx, then statistical, then Average, and then use the mouse to select the proper range. Do this for Bartman and then copy the cell for the other items. b. Calculate the standard deviation of the returns for Bartman, Reynolds, and the Market Index. (Hint: Use the sample standard deviation formula given in the chapter, which corresponds to the STDEV function in Excel.) Use the function wizard to calculate the standard deviations. Bartman 31.5% Reynolds 9.7% Index 13.8%

Standard deviation of returns Bartman is more risky, Reynolds least risky

c. Now calculate the coefficients of variation Bartman, Reynolds, and the Market Index. standard deviation/average return Bartman 1.07 Reynolds 3.63 Index 0.67

Coefficient of Variation

Reynolds most risky because coefficient is the highest comparatively, risk (sd) per unit of return is the highest d. Construct a scatter diagram graph that shows Bartmans and Reynolds returns on the vertical axis and the Market Indexs returns on the horizontal axis. It is easiest to make scatter diagrams with a data set that has the X-axis variable in the left column, so we reformat the returns data calculated above and show it just below. Year 2010 2009 2008 2007 2006 Index 32.8% 1.2% 34.9% 14.8% 19.0% Bartman 24.7% -4.2% 62.8% 2.9% 61.0% Reynolds -1.1% 13.2% -10.0% -0.4% 11.7%

Stock Returns vs. Index

0.7 0.6 0.5 Stock Returns 0.4 0.3 0.2 0.1 Bartman Reynolds

0 -0.10.0% -0.2 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%

Index Returns

To make the graph, we first selected the range with the returns and the column heads, then clicked the chart wizard, then choose the scatter diagram without connected lines. That gave us the data points. We then used the drawing toolbar to make free-hand ("by eye") regression lines, and changed the lines color and weights to match the dots.

Bartman moves with the market and Reynolds moves counter/oppositute to the market. Bartman has a positive beta and Reynolds has a ne

e. Estimate Bartmans and Reynoldss betas as the slopes of regression lines with stock returns on the vertical axis (y-axis) and market return on the horizontal axis (x-axis). (Hint: use Excels SLOPE function.) Are these betas consistent with your graph? Bartman's beta = Reynolds' beta = 1.54 -0.56

Betas follow same pattern as before, Reynolds less risky than average in CAPM, Bartman more risky than average

f. The risk-free rate on long-term Treasury bonds is 6.04%. Assume that the market risk premium is 5%. What is the expected return on the market? Now use the SML equation to calculate the two companies' required returns. Market risk premium (RP M) = Risk-free rate = Expected return on market = = = Required return Bartman: Required return 5.000% 6.040% Risk-free rate 6.040% 11.040% = + + Market risk premium 5.000%

Risk-free rate +

Market Risk Premium

Beta

= =

6.040% 13.737%

5.000%

1.539

Reynolds: Required return

= =

6.040% 3.238%

5.000%

-0.560

Reynolds has low expected return, but will off if market declines. Negative beta stocks are rare so the data is difficult to comprehend.

g. If you formed a portfolio that consisted of 50% Bartman stock and 50% Reynolds stock, what would be its beta and its required return? The beta of a portfolio is simply a weighted average of the betas of the stocks in the portfolio, so this portfolio's beta would be: Portfolio beta = 0.49

h. Suppose an investor wants to include Bartman Industries stock in his or her portfolio. Stocks A, B, and C are currently in the portfolio, and their betas are 0.769, 0.985, and 1.223, respectively. Calculate the new portfolios required return if it consists of 25% of Bartman, 15% of Stock A, 40% of Stock B, and 20% of Stock C. Beta 1.539 0.769 0.985 1.223 1.139 = = = Risk-free rate + 6.04% 11.73% Market Risk Premium * 5.00% * Beta 1.139 Portfolio Weight 25% 15% 40% 20% 100%

Bartman Stock A Stock B Stock C Portfolio Beta = Required return on portfolio:

Year #REF! #REF! #REF! #REF! #REF!

Index #REF! #REF! #REF! #REF! #REF!

Bartman #REF! #REF! #REF! #REF! #REF!

Reynolds #REF! #REF! #REF! #REF! #REF!

Chart Title
0.7 Series1 0.6 Year Index Bartman Reynolds 2010 0.32761 0.247458 -0.01052 2009 0.01218 -0.04182 0.132308 2008 0.349074 0.627907 -0.10044 2007 0.148466 0.028571 -0.00417 2006 0.190462 0.609836 0.116592 Series2 0.5 0.4 Axis Title 0.3 0.2 0.1 0 -0.1 0 -0.2 Axis Title Series9 0.1 0.2 0.3 0.4 Series3 Series4 Series5 Series6 Series7 Series8