The security market line (SML) is simply a plot of expected returns of investments with respect to its beta, market risk. Expected values are calculated with the following equation:

Formula 11.15

Es= rf + Bs(Emkt - rf)
rf = the risk-free rate

Bs = the beta of the investment
Emkt = the expected return of the market
Es = the expected return of the investment
The beta is thus the sensitivity of the investment to the market or current 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. Through the use of the SML as a means to calculate a company's WACC, this risk profile would be accounted for.

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.

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

The project's required return on retained earnings is thus 16% and should be used in our calculation of WACC.

Estimating Beta
In risk analysis, estimating the beta of a project is quite important. But like many estimations, it can be difficult to determine.

The two most widely used methods of estimating beta are:

1. Pure-Play Method
When using the pure-play method, a company seeks out companies with a product line that is similar to the line for which the company is trying to estimate the beta. Once these companies are found, the company would then take an average of those betas to determine its project beta.

Suppose Newco would like to add beer to its existing product line of soda. Newco is quite familiar with the beta of making soda given its history. However, determining the beta for beer is not as intuitive for Newco as it has never produced it.

Thus, to determine the beta of the new beer project, Newco can take the average beta of other beer makers, such as Anheuser Busch and Coors.

2. Accounting-Beta Method
When using the accounting-beta method, a company would run a regression using the company's return on assets (ROA) against the ROA for market benchmark, such as the S&P 500. The accounting beta is the slope coefficient of the regression.

The typical procedure for developing a risk-adjusted discount rate is as follows:

1. A company first begins with its cost of capital for the firm.
The cost of capital then must be adjusted for the riskiness of the project, by adjusting the company's cost of capital either up or down depending on the risk of the project relative to the firm.

For projects that are riskier, the company's WACC would be adjusted higher and if the project is less risky, the company's WACC is adjusted lower. The main issue in this procedure is that it is subjective.

Capital Rationing
Essentially, capital rationing is the process of allocating the company's capital among projects to maximize shareholder return.

When making decisions to invest in positive net-present-value (NPV) projects, companies continue to invest until their marginal returns equal their marginal cost of capital. There are times, however, when a company may not have capital to do this. As such, a company must ration its capital among the best combination of projects with the highest total NPV.

Factors that Influence a Company's Capital-Structure Decision

Related Articles
  1. Investing

    Beta: Gauging Price Fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  2. Investing

    Beta: Know The Risk

    Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here.
  3. Investing

    High Beta – Low Beta Stocks Define Volatility Trades

    We compare the Beta values obtained from financial sources. Also, how to compute Beta using Excel.
  4. Investing

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  5. Investing

    What is a Security Market Line?

    The security market line graphs the systematic risk versus return of the whole market at a certain time, and shows all risky marketable securities.
  6. Investing

    Build Diversity Through Beta

    In conjunction with stock valuation ratios like the price-to-earnings ratio and the price-to-earnings-growth ratio, a stock's measure of volatility known as beta can help investors build a diversified ...
  7. Financial Advisor

    Calculating Beta: Portfolio Math For The Average Investor

    Beta is a useful tool for calculating risk, but the formulas provided online aren't specific to you. Learn how to make your own.
  8. Investing

    Understanding Beta

    Beta is a measure of volatility. Find out what this means and how it affects your portfolio.
  9. Investing

    3 Cases When Beta Does Not Measure Volatility of Stocks

    Examine the theoretical and statistical relationship between beta and volatility to identify three factors that limit beta's explanatory value.
  10. Investing

    Smart Beta: Can Low Beta Equal High Risk?

    Low beta may not necessarily mean low risk when it comes to some smart beta strategies.
Frequently Asked Questions
  1. I'm about to retire. If I pay off my mortgage with after-tax money I have saved, I can save 6.5%. Should I do this?

    Only you and your financial advisor, family, accountant, etc. can answer the "should I?" question because there are many ...
  2. My wife and I both converted our Traditional IRAs to Roth IRAs over a decade ago and have invested the maximum allowed each year since. We're buying our first home soon. Do we both qualify for one-time, tax-free, $10,000 distributions?

    You and your spouse each qualify for a penalty-free distribution of up to $10,000 for the purchase, acquisition or construction ...
  3. Is a Thrift Savings Plan (TSP) a qualified retirement plan?

    Take advantage of the government's retirement plan for employees with the Thrift Savings Plan. As with a 401(k), contributions ...
  4. Who manages the assets in a Roth 401(k) account?

    Learn how to personally manage the assets in your Roth 401(k) plan and determine the best options available to help meet ...
Trading Center