Chargers Case

8/13/2019 Chargers Case

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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, 19942003. 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

Year Cash Flow MVBEGINNING MVENDING MV Rate of Return (%)

1994 1,000 20,000 22,000 2,000 15.00

1995 1,500 22,000 21,000 -1,000 2.27

1996 1,400 21,000 24,000 3,000 20.95

1997 1,700 24,000 22,000 -2,000 -1.25

1998 1,900 22,000 23,000 1,000 13.18

1999 1,600 23,000 26,000 3,000 20.00

2000 1,700 26,000 25,000 -1,000 2.69

2001 2,000 25,000 24,000 -1,000 4.00

2002 2,100 24,000 27,000 3,000 21.25

2003 2,200 27,000 30,000 3,000 19.26

SUM 117.36

AVERAGE RATE OF RETURN 11.74

ASSET Y

Year Cash Flow MVBEGINNING MVENDING MV Rate of Return (%)

1994 1,500 20,000 20,000 0 7.50

1995 1,600 20,000 20,000 0 8.00

1996 1,700 20,000 21,000 1,000 13.50

1997 1,800 21,000 21,000 0 8.57

1998 1,900 21,000 22,000 1,000 13.81

1999 2,000 22,000 23,000 1,000 13.64

2000 2,100 23,000 23,000 0 9.13

2001 2,200 23,000 24,000 1,000 13.91

2002 2,300 24,000 25,000 1,000 13.75

2003 2,400 25,000 25,000 0 9.60

SUM 111.41

AVERAGE RATE OF RETURN 11.14

Formulae used:

Annual Rate of Return =Cash Flow + MV

MVBEGINNING

Average Rate of Return = Annual Rate of Return23994

10


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B. Standard Deviation and Coefficients of Variation

ASSET X

Year Annual Rate of Return (rj) Average Rate of Return () (rj- )2

199415.00 11.74 10.651995 2.27 11.74 89.55

1996 20.95 11.74 84.94

1997 -1.25 11.74 168.63

1998 13.18 11.74 2.09

1999 20.00 11.74 68.30

2000 2.69 11.74 81.79

2001 4.00 11.74 59.84

2002 21.25 11.74 90.52

2003 19.26 11.74 56.60

SUM 712.92

STANDARD DEVIATION OF RETURNS (%), ASSET X 8.90

COEFFICIENT OF VARIATION OF RETURNS 0.76

ASSET Y

Year Annual Rate of Return (rj) Average Rate of Return () (rj- )2

1994 7.50 11.14 13.26

1995 8.00 11.14 9.87

1996 13.50 11.14 5.56

1997 8.57 11.14 6.60

1998 13.81 11.14 7.12

1999 13.64 11.14 6.23

2000 9.13 11.14 4.04

2001 13.91 11.14 7.68

2002 13.75 11.14 6.81

2003 9.60 11.14 2.37

SUM 69.55

STANDARD DEVIATION OF RETURNS (%), ASSET Y 2.78

COEFFICIENT OF VARIATION OF RETURNS 0.25

Formulae used:

SSET = (rj )

223994

1 0 1

Coefficient of Variation =SSET


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rX

rYrm

RF

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80

Security Market Line

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

Asset Beta, bj Risk-free Return (%), RF Market Return (%), rm Required Rate of Return (%), rj

X 1.60 7 10 11.80

Y 1.10 7 10 10.30

SML:

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.


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rX

rYrm

RF

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

0.00 0.50 1.00 1.50 2.00

SML 1

SML 2

E. Recommendations

For the reasons previously expounded, J. Sayou is advised to pick Asset Yto 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

CAPM

Asset Beta (bj) Risk-free Return (%), RF Market Return (%), rm Required Rate of Return (%), rj

X 1.60 8 11 12.80Y 1.10 8 11 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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rX

rYrm

RF

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

0.00 0.50 1.00 1.50 2.00

SML 1

SML 3

F.2. Decrease in Risk Aversion of Investors

CAPM

Asset Beta (bj) Risk-free Return (%), RF Market Return (%), rm Required Rate of Return (%), rj

X 1.60 7 9 10.20

Y 1.10 7 9 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.

Documents

Chargers Case