Accounting

1. Intuitively, which of the three firms would you say is the most risky? Least risky?

Intuitively, Amazon is the most risky company and GE is the least risky company. The reason is that GE is in its mature phase of business life cycle, and is a multiple line business, which implies lower risk from diversification. Amazon is in its growing phase and is a single line business. The TJX Companies is a single line business.

2. According to the standard version of the CAPM, risk is captured by beta. Calculate the CAPM beta for each of the three firms, using the returns in the attached spreadsheet labeled as Ѓgdiscount rate-returnsЃh (you can do this in directly in excel, or, if you prefer, using a separate statistics program). How does the ranking of the estimated betas compare to your intuitive answer to Question 1?

Ѓ@ GE TJX Amazon

alpha 0.727105366 0.550931113 12.9286468

beta 1.130431463 1.208639732 2.589165097

Rsq 0.534519433 0.170198571 0.157280478

The regression shows GE has the smallest beta, while Amazon has the biggest. ItЃfs consistent with the intuition.

3. How well does the market return explain individual firm returns (as measured by each regression's R-square)? What is the intercept in each regression, and what does that tell you about how well the model works for discount rate estimation?

The market return explains GE pretty well, with an R-sq of 53%. But it explains TJX and Amazon poorly, with R-sq of 17% and 16% respectively.

The intercept of GE and TJX is close to zero, but itЃfs over 12 for Amazon. CAPM works well with stable companies such as GE, but explains poorly for growing, small companies.

Using reasonable proxies for the present, annual, risk-free rate and the expected market risk premium, calculate the cost of equity (the equity discount rate) for each firm. The average annual return of equities in the US (calculated over the last 75 years) is around 12-13%. Do your estimates seem reasonable in light of this?

Ѓ@ GE TJX Amazon

alpha 0.727105366 0.550931113 12.9286468

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