Introduction to Finance BU6009

Assessment four – week 4

Instructions:

1. The assessment must be submitted before the end of the week.

2. Late submission will result in a reduction of 5% as per institutional policy. 

Question:

Yousif Sadek, a financial analyst for Itqan Products, a manufacturer of Sports equipment, 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, Yousif gathered data on the annual cash flow
and beginning- and end-of-year values of each asset over the immediately preceding 10 years, 2010–
2019. These data are summarized in the accompanying table. Yousif’s investigation suggests that both
assets, on average, will tend to perform in the future just as they

Return Data for Assets X and Y, 2010-2019

Asset X Asset Y
Value Value

Year Cash flow Beginning Ending Cash flow Beginning Ending

2010 SI,000 $20,000 $22,000 $1,500 $20,000 $20,000

2011 1,500 22,000 21,000 1,600 20,000 20,000

2012 1,400 21,000 24,000 1,700 20,000 21,000

2013 1,700 24,000 22,000 1,800 21,000 21,000

2014 1,900 22,000 23,000 1,900 21,000 22,000

2015 1,600 23,000 26,000 2,000 22,000 23,000
2016 1,700 26,000 25,000 2,100 23,000 23,000
2017 2,000 25,000 24,000 2,200 23,000 24,000

2018 2,100 24,000 27,000 2,300 24,000 25,000

2019 2,200 27,000 30,000 2,400 25,000 25,000

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.

Yousif 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 10 years. The capital asset pricing model
Introduction to Finance BU6009
Assessment four – week 4

(CAPM) can be used to assess the asset’s risk as part of the firm’s portfolio of assets. Applying some
sophisticated quantitative techniques, Yousif estimated betas for assets X and Y of 1.60 and 1.10,
respectively. Also, he found that the risk-free rate is currently 7% and that the market return is 10%.

Required

a. Calculate the annual rate of return for each asset in each of the 10 preceding years and use those
values to find the average annual return for each asset over the 10-year period.

Asset x:

Annual rate= end value- beginning value+ cashflow\ beginning value

2010: $22,000-$20,000+ SI,000\$20,000= 0.15= 15%
2011: $21000-$22000+1500\22000=0.0227= 2.27%
2012: 24,000-21,000+1,400\21,000=0.209= 20.9%
)1.25%( =)0.0125(=24,000\22,000-24,000+1,700 :2013
2014: 23,000-22,000+1,900\22,000= 13.18%
2015: 26,000-23,000+1,600\23,000= 20%
2016: 25,000-26,000+1,700\26,000= 2.69%
2017: 24,000-25,000+2,000\25,000= 4%
2018: 27,000-24,000+2,100\24,000= 21.25%
19.25% =27,000\30,000-27,000+2,200 :2019
average annual return:15+2.27+20.9+(-1.25)+13.18 +20+2.69+4+21.25+19.25\10=11.729

:Asset y

2010: $20,000-$20,000+$1,500\$20,000=7.5%
2011: 20,000-20,000+1,600\20,000=8%
2012: 21,000-20,000+1,700\20,000=13.5%
2013: 21,000-21,000+1,800\21,000=8.5%
2014: 22,000-21,000+1,900\21,000=13.8%
2015: 23,000-22,000+2,000\22,000=13.6%
2016: 23,000-23,000+2,100\23,000=9.1%
2017: 24,000-23,000+2,200\23,000=13.9%
2018: 25,000-24,000+2,300\24,000=13.75%
2019: 25,000-25,000+2,400\25,000=9.6%

average annual return: 7.5+8+13.5+8.5+13.8+13.6+9.1+13.9+13.75+9.6\10= 11.125%

standard deviation:[(annual rate-average annual)^2+….. ]\n-1= Square root

coefficient variation: average annual SD\ average annual return

:Asset x
SD:[(15-11.729)^2+(2.27-11.729)^2+(20.9-11.729)^2+((-1.25)-11.729)^2+(13.18-11.729)^2+(20-
11.729)^2+(2.69-11.729)^2+(4-11.729)^2+(21.25-11.729)^2+(19.25-11.729)^2]\9=79.099
SD= Square root = 8.89%
CV= 8.89\11.729= 0.758
Introduction to Finance BU6009
Assessment four – week 4

:Asset y

SD:[(7.5-11.125)^2+(8-11.125)^2+(13.5-11.125)^2+(8.5-11.125)^2+(13.8-11.125)^2+(13.6-
11.125)^2+(9.1-11.125)^2+(13.9-11.125)^2+(13.75-11.125)^2+(9.6-11.125)^2]\9=7.746
SD= Square root 7.746=2.78%
CV=2.78\11.125=0.249

b. Use the returns calculated in part to find (1) the standard deviation and (2)the coefficient of variation
of the returns for each asset over the 10-year period 2010–2019.

CV in X values is higher than y value, so the investment has more volatility relative to its
expected return.

c. Use your findings in parts a and b to evaluate and discuss the return and risk associated with each
asset. Which asset appears to be preferable? Explain.

CV in X values is higher, so the investment has more volatility relative to its expected return

d. Use the CAPM to find the required return for each asset. Compare this value with the average annual
returns calculated in part a.

CAPM: required rate return=risk free rate+[beta*(market return-risk free rate)]

Asset X: 7%+[(1.60*10%-7%)]=0.16%
Asset Y: 7%+[(1.10*10%-7%)]=0.11%

e. Compare your findings in parts c and d. What recommendations would you give Yousif about investing
in either of the two assets? Explain to Yousif why he is better off using beta rather than the standard
deviation and coefficient of variation to assess the risk of each asset.

It recommended that he should invest in asset X because it is less exposed to the market and it
have a lower rate of return