CP

Adjusting the Cost of Capital for Risk 243

Thus, investors in Huron’s stock would have a required return of:

Even though the investors require an overall return of 13.72 percent, they would

expect a return of at least 13.6 percent from the steel division, 16.0 percent from the

barge division, and 10.0 percent from the distribution center.

Figure 6-1 gives a graphic summary of these concepts as applied to Huron Steel.

Note the following points:

1. The SML is the same Security Market Line that we discussed in Chapter 3. It
   shows how investors are willing to make trade-offs between risk as measured by
   beta and expected returns. The higher the beta risk, the higher the rate of return
   needed to compensate investors for bearing this risk. The SML specifies the nature
   of this relationship.


2. Huron Steel initially has a beta of 1.1, so its required rate of return on average-risk
   investments in its original steel operations is 13.6 percent.


3. High-risk investments such as the barge line require higher rates of return,
   whereas low-risk investments such as the distribution center require lower rates of
   return.


4. If the expected rate of return on a given capital project lies above the SML, the ex-
   pected rate of return on the project is more than enough to compensate for its risk,
   and the project should be accepted. Conversely, if the project’s rate of return lies
   below the SML, it should be rejected. Thus, Project M in Figure 6-1 is acceptable,
   whereas Project N should be rejected. N has a higher expected return than M, but
   the differential is not enough to offset its much higher risk.


5. For simplicity, the Huron Steel illustration is based on the assumption that the
   company used no debt financing, which allows us to use the SML to plot the com-
   pany’s cost of capital. The basic concepts presented in the Huron illustration also

RHuron7%(6%)1.1213.72%.

FIGURE 6-1 Using the Security Market Line for Divisions

rBarge = 16.0

rSteel = 13.6

rCenter = 10.0

r = 7.0RF Distribution

Center

Division

Steel

Division

Barge

Division

Acceptance Region

SML = r + (RP )b

= 7% + (6%)b

RF

N Rejection Region

M

0 0.5 1.1 1.5 2.0 Risk (b)

Rate of Return

(%)

MRF

240 The Cost of Capital