Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 13. Return, Risk, and the

Security Market Line

(^470) © The McGraw−Hill
Companies, 2002
THE SML AND THE COST OF CAPITAL:
A PREVIEW
Our goal in studying risk and return is twofold. First, risk is an extremely important con-
sideration in almost all business decisions, so we want to discuss just what risk is and
how it is rewarded in the market. Our second purpose is to learn what determines the ap-
propriate discount rate for future cash flows. We briefly discuss this second subject now;
we will discuss it in more detail in a subsequent chapter.
The Basic Idea
The security market line tells us the reward for bearing risk in financial markets. At an
absolute minimum, any new investment our firm undertakes must offer an expected re-
turn that is no worse than what the financial markets offer for the same risk. The reason
for this is simply that our shareholders can always invest for themselves in the financial
markets.
The only way we benefit our shareholders is by finding investments with expected
returns that are superior to what the financial markets offer for the same risk. Such an
investment will have a positive NPV. So, if we ask, “What is the appropriate discount
rate?” the answer is that we should use the expected return offered in financial markets
on investments with the same systematic risk.
In other words, to determine whether or not an investment has a positive NPV, we es-
sentially compare the expected return on that new investment to what the financial mar-
ket offers on an investment with the same beta. This is why the SML is so important; it
tells us the “going rate” for bearing risk in the economy.
The Cost of Capital
The appropriate discount rate on a new project is the minimum expected rate of return
an investment must offer to be attractive. This minimum required return is often called
the cost of capitalassociated with the investment. It is called this because the required
return is what the firm must earn on its capital investment in a project just to break even.
It can thus be interpreted as the opportunity cost associated with the firm’s capital in-
vestment.
Notice that when we say an investment is attractive if its expected return exceeds
what is offered in financial markets for investments of the same risk, we are effectively
using the internal rate of return (IRR) criterion that we developed and discussed in
Chapter 9. The only difference is that now we have a much better idea of what deter-
mines the required return on an investment. This understanding will be critical when we
discuss cost of capital and capital structure in Part 7 of our book.
CONCEPT QUESTIONS
13.7a What is the fundamental relationship between risk and return in well-function-
ing markets?
13.7bWhat is the security market line? Why must all assets plot directly on it in a well-
functioning market?
13.7c What is the capital asset pricing model (CAPM)? What does it tell us about the
required return on a risky investment?
442 PART FIVE Risk and Return

13.8

cost of capital
The minimum required
return on a new
investment.