Using the Security Market Line to Set Project Hurdle Rates
Summary
The document explains how the Security Market Line (SML), commonly associated with CAPM, can be used to assess a corporate project even though a new product line is not itself a traded security. The central argument is that a project's expected return should be compared with the return investors require for bearing similar systematic risk. That required return represents a benchmark for deciding whether to undertake a project and is tied to the company's cost of capital.
The discussion also gives limits and context rather than presenting the SML as universally reliable. One response notes that regulated utilities may use the framework in arguments about rates, while another cautions that its efficient-market assumptions can make it a poor fit for some real-world investment settings. A company sale example illustrates that buyers may instead assess the level and variability of cash flows against market return requirements. The document offers conceptual perspectives, not a calculation procedure or empirical test.
Key ideas
- The SML links systematic risk to the return investors require for bearing that risk.
- CAPM can provide a hurdle-rate benchmark for evaluating a corporate project.
- A project should offer a return commensurate with the risk borne by shareholders or lenders.
- The SML relies on assumptions that may limit its usefulness in some industries and decisions.
- Cash flow level and variability can also inform comparisons of business value.
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# Security Market Line & Required Rate of Return for Projects
# Security Market Line & Required Rate of Return for Projects
A standard definition of the Security Market Line is as follows:
> The security market line ("SML" or "characteristic line") graphs the systematic (or market) risk versus the return of the whole market at a certain time and shows all risky marketable securities.
And an application of the SML for investment decision is as follows (according to my Corporate Finance Book):
> to determine whether an investment has a positive NPV, we essentially compare the expected return on that new investment to what the financial market 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.
If one were to use these pieces of information, among many others, one would conclude that when choosing to invest in bonds, stocks at a certain risk one would at least expect returns that a similar investment would provide. However, the SML is not only applicable for such decisions but also for deciding the cost of capital or required rate of return for projects that a company may undertake. There are even maths in Finance books where they provide Beta, Expected Return and other variables for opening a new product line or some project.
However, In these events how would one find similar investment from SML? Opening a new product line, or running some project is different from stock or bond investments! How can they be comparable?
## Answer by Neeraj (score 1)
https://quant.stackexchange.com/a/24568
Your question holds some water, but it is all about providing return atleast expected by the shareholders (cost of capital). Remember, it is shareholders money that gets invested in such project (if not borrowed). If project does not provide return that is being expected by the shareholders (cost of their capital or risk adjusted return) then why would they continue to hold share of such company. Managers require to select only those projects that could provide return atleast expected by the shareholders.
In short, CAPM provide a benchmark return which help the managers to decide which projects to choose or reject for investment decision.
## Answer by horseless (score 0)
https://quant.stackexchange.com/a/24577
I think the answer needs to address why the question is being asked. Some industries such as utilities obsess over this model. Utilities are highly regulated and will use this framework to argue for rate increases to regulators. Other industries, not so such. It would likely be a severely career limiting move to use the SML to suggest a purchase at a buy side fixed income shop. Systemic risk is very important, but the SML framework is based on some very strict efficient markets assumptions which are fictional. Remember, this is a textbook you are referring to and not the real world. To answer your last point, I know someone who sold his company to a much larger company, and part of the pricing was to look at the amount and variability of his cash flows and compare it to what the market was requiring at the time.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.