The SML Approach

In Chapter 13, we discussed the security market line, or SML. Our primary conclusion was that the required or expected return on a risky investment depends on three things:

1. The risk-free rate, Rf

3. The systematic risk of the asset relative to average, which we called its beta coefficient, p

Using the SML, we can write the expected return on the company's equity, E(Re), as: e(Re) = Rf + pe X [e(Rm) — Rf]

where pE is the estimated beta. To make the SML approach consistent with the dividend growth model, we will drop the Es denoting expectations and henceforth write the required return from the SML, RE, as:

3There in an implicit adjustment for risk because the current stock price is used. All other things being equal, the higher the risk, the lower is the stock price. Further, the lower the stock price, the greater is the cost of equity, again assuming all the other information is the same.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

PART SIX Cost of Capital and Long-Term Financial Policy

Betas and T-bill rates can both be found at . www.bloomberg.com.

Implementing the Approach To use the SML approach, we need a risk-free rate, Rf, an estimate of the market risk premium, RM - Rf, and an estimate of the relevant beta, (E. In Chapter 12 (Table 12.3), we saw that one estimate of the market risk premium (based on large common stocks) is 9.1 percent. U.S. Treasury bills are paying about 2.0 percent as this chapter is being written, so we will use this as our risk-free rate. Beta coefficients for publicly traded companies are widely available.4

To illustrate, in Chapter 13, we saw that IBM had an estimated beta of .95 (Table 13.8). We could thus estimate IBM's cost of equity as:

Thus, using the SML approach, we calculate that IBM's cost of equity is about 10.65 percent.

Advantages and Disadvantages of the Approach The SML approach has two primary advantages. First, it explicitly adjusts for risk. Second, it is applicable to companies other than just those with steady dividend growth. Thus, it may be useful in a wider variety of circumstances.

There are drawbacks, of course. The SML approach requires that two things be estimated, the market risk premium and the beta coefficient. To the extent that our estimates are poor, the resulting cost of equity will be inaccurate. For example, our estimate of the market risk premium, 9.1 percent, is based on about 75 years of returns on a particular portfolio of stocks. Using different time periods or different stocks could result in very different estimates.

Finally, as with the dividend growth model, we essentially rely on the past to predict the future when we use the SML approach. Economic conditions can change very quickly, so, as always, the past may not be a good guide to the future. In the best of all worlds, both approaches (the dividend growth model and the SML) are applicable and the two result in similar answers. If this happens, we might have some confidence in our estimates. We might also wish to compare the results to those for other, similar, companies as a reality check.

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