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)
Where:
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.

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.

Answer:
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.
2.
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

    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.
  2. 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 ...
  3. 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.
  4. Investing

    Understanding Beta

    Beta is a measure of volatility. Find out what this means and how it affects your portfolio.
  5. 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.
  6. Investing

    5 High-Beta Stocks To Watch

    Check out five high-beta stocks that can help make your portfolio more exciting.
  7. Investing

    The Biggest Trend in Investing May be Wrong for You

    3 reasons why you may want to think twice before allocating Smart Beta to your portfolio.
  8. Investing

    5 Low-Beta DJIA Stocks To Know

    Check out five low-beta stocks that can help you to diversify your portfolio.
  9. Investing

    Smart Beta ETF Myths and Misconceptions

    Discover smart beta exchange-traded funds (ETFs), and learn about some of the common misconceptions and characteristics of this type of product.
  10. Investing

    Smart Beta ETFs: An Overview

    What are Smart Beta ETFs?
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center