4/2/2009

Chapter 6. Solution to 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

On a stand-alone basis, it would appear that Bartman is the most risky, Reynolds the least risky. c. Now calculate the coefficients of variation Bartman, Reynolds, and the Market Index. Divide the standard deviation by the average return: Bartman 1.07 Reynolds 3.63 Index 0.67

Coefficient of Variation

Reynolds now looks most risky, because its risk (SD) per unit of return is 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

Stocks' Returns 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0%0.0% -20.0%

Bartman Reynolds

10.0%

20.0% Index Returns

30.0%

40.0%

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. It is clear that Bartman moves with the market and Reynolds moves counter to the market. So, Bartman has a positive beta and Reynolds a negative one. 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

Note that these betas are consistent with the scatter diagrams we constructed earlier. Reynolds' beta suggests that it is less risky than average in a CAPM sense, whereas Bartman is 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 (RPM) = 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

= =

6.040% 13.737%

5.000%

Reynolds: Required return

= =

6.040% 3.238%

5.000%

This suggests that Reynolds' stock is like an insurance policy that has a low expected return, but it will pay off in the event of a market decline. Actually, it is hard to find negative beta stocks, so we would not be inclined to believe the Reynolds data. 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 1.423, 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 1.423 1.179 = = = Risk-free rate 6.04% 11.93% + Market Risk Premium * 5.00% * Beta 1.179 Portfolio Weight 25% 15% 40% 20% 100%

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

What is the expected

Beta

1.539

-0.560