Principles of Managerial Finance

CHAPTER 5 Risk and Return 241

22. A firm’s beta can change over time as a result of changes in the firm’s asset mix, in its financing mix, or in exter-
    nal factors not within management’s control, such as earthquakes, toxic spills, and so on. The impacts of changes in
    beta on value are discussed in Chapter 7.

Shifts in the Security Market Line

The security market line is not stable over time, and shifts in the security market

line can result in a change in required return. The position and slope of the SML

are affected by two major forces—inflationary expectations and risk aversion—

which are analyzed next.^22

Changes in Inflationary Expectations Changes in inflationary expectations

affect the risk-free rate of return, RF.The equation for the risk-free rate of

return is

RFk*IP (5.9)

This equation shows that, assuming a constant real rate of interest,k*, changes in

inflationary expectations, reflected in an inflation premium,IP,will result in corre-

sponding changes in the risk-free rate. Therefore, a change in inflationary expecta-

tions that results from events such as international trade embargoes or major

changes in Federal Reserve policy will result in a shift in the SML. Because the risk-

free rate is a basic component of all rates of return, any change inRFwill be

reflected inallrequired rates of return.

Changes in inflationary expectations result in parallel shifts in the SML in

direct response to the magnitude and direction of the change. This effect can best

be illustrated by an example.

EXAMPLE In the preceding example, using CAPM, the required return for asset Z, kZ,was
found to be 13%. Assuming that the risk-free rate of 7% includes a 2% real
rate of interest, k*, and a 5% inflation premium, IP,then Equation 5.9 con-
firms that

RF2%5%7%

Now assume that recent economic events have resulted in an increase of 3%

in inflationary expectations, raising the inflation premiumto 8% (IP 1 ). As a

result, all returns likewise rise by 3%. In this case, the new returns (noted by sub-

script 1) are

RF 1 10% (rises from 7% to 10%)

km 1 14% (rises from 11% to 14%)

Substituting these values, along with asset Z’s beta (bZ) of 1.5, into the CAPM

(Equation 5.8), we find that asset Z’s new required return (kZ 1 ) can be calculated:

kZ 1 10%[1.5(14%10%)]10%6% 1



6



%

Comparing kZ 1 of 16% to kZof 13%, we see that the change of 3% in asset Z’s

required return exactly equals the change in the inflation premium. The same 3%

increase results for all assets.