Security Market Line And Beta Basics

Topics: Capital asset pricing model, Investment, Risk Pages: 6 (2158 words) Published: November 23, 2014
11/8/2014

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Complete Guide To Corporate Finance
Chapter One

Chapter Two

Chapter Three

Chapter Four

Chapter Five

Decisions

4.5.1 An Introduction To Risk And Return

4.3 Project Analysis And

4.5.2 Expected Return, Variance And Standard Deviation

Valuation

AAA |

Of A Portfolio

4.4 Capital Market History

4.5.3 Portfolios

4.5 Return, Risk And The

4.5.4 Expected And Unexpected Returns

Security Market Line

4.5.5 Systematic And Unsystematic Risk

Return, Risk And The Security Market Line Security Market Line And Beta Basics The security market line ("SML" or "characteristic line") graphs the systematic (or market) risk versus the return of the whole market at a certain time and shows all risky marketable securities. The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The security market line is a useful tool for determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.​

assumed.Expected
Expected values for the SML are calculated with the

following equation:

Es = rf + Bs(Emkt - rf)

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Where: rf = the risk-free rate

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Bs = the beta of the investment

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Emkg = the expected return of the market
Es = the expected return of the investment

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The beta is thus the sensitivity of the investment to the market or current http://www.investopedia.com/walkthrough/corporate-finance/4/return-risk/security-market-line.aspx

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11/8/2014

Security Market Line And Beta Basics - Complete Guide To Corporate Finance | Investopedia

portfolio. It is the measure of the riskiness of a project. When taken in isolation, a project may be considered more or less risky than the current risk profile of a company. By using the SML as a means to calculate a company's WACC, this risk profile would be accounted for.

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Example:
When a new product line for Newco is considered, the project's beta is 1.5. Assuming the risk-free rate is 4% and the expected return on the market is 12%, compute the cost of equity for the new product line.

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Answer:
Cost of equity = rf + Bs(Emkt - rf) = 4% + 1.5(12% - 4%) = 16%

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The project's required return on retained earnings is therefore 16%, a number which should be used in our calculation of weighted average cost of capital (WACC
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In risk analysis, estimating the beta of a project is quite important. But like many estimations, it can be difficult to determine....
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