Build a Model
Solution 7/16/15
Chapter: 6
Problem: 15
a. Use the data given to calculate annual returns for Goodman, Landry, 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 2010 because you do not have 2009 data.)
Data as given in the problem are shown below:
Goodman Industries Landry Incorporated Market Index
Year Stock Price Dividend Stock Price Dividend Includes Divs.
2016 $25.88 $1.73 $73.13 $4.50 17,495.97
2015 $22.13 $1.59 $78.45 $4.35 13,178.55
2014 $24.75 $1.50 $73.13 $4.13 13,019.97
2013 $16.13 $1.43 $85.88 $3.75 9,651.05
2012 $17.06 $1.35 $90.00 $3.38 8,403.42
2011 $11.44 $1.28 $83.63 $3.00 7,058.96
We now calculate the rates of return for the two companies and the index:
Goodman Landry Index
2016

Kenneth D. Jackson: Change in stock price plus any dividends, divided by the previous stock price 2015
2014
2013
2012
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 Goodman and then copy the cell for the other items.
b. Calculate the standard deviation of the returns for Goodman, Landry, 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.
Goodman Landry Index
Standard deviation of returns
c. Construct a scatter diagram graph that shows Goodman’s and Landry’ returns on the vertical axis and the Market Index’s 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 Index Goodman Landry
2016 0.0% 0.0% 0.0%
2015 0.0% 0.0% 0.0%
2014 0.0% 0.0% 0.0%
2013 0.0% 0.0% 0.0%
2012 0.0% 0.0% 0.0%
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.
d. Estimate Goodman’s and Landry’s 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 Excel’s SLOPE function.) Are these betas consistent with your graph?
Goodman’s beta =
Landry’ beta =
e. 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) = 5.000%
Risk-free rate = 6.040%
Expected return on market = Risk-free rate + Market risk premium
= 6.040% + 5.000%
= 11.040%
Required return = Risk-free rate + Market Risk Premium x Beta
Goodman:
Required return =
=
Landry:
Required return = x
=
f. If you formed a portfolio that consisted of 50% Goodman stock and 50% Landry 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 =
g. Suppose an investor wants to include Goodman 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 portfolio’s required return if it consists of 25% of Goodman, 15% of Stock A, 40% of Stock B, and 20% of Stock C.
Beta Portfolio Weight
Goodman 25%
Stock A 0.769 15%
Stock B 0.985 40%
Stock C 1.423 20%
100%
Portfolio Beta =
Required return on portfolio: = Risk-free rate + Market Risk Premium * * Beta
=
=