Corporate Finance Management: SML, CML, MPT, CAPM, DGM, and WACC

Running head: CORPORATE FINANCE MANAGEMENT
Corporate Finance Management
Name of the Student
Name of the University
Author Note

1CORPORATE FINANCE MANAGEMENT
Answer to part (A)
The Security Market Line (SML) is a tool that is used to evaluate the portfolios which
is based on the Capital Asset Pricing Model. The Security Market Line establishes a
relationship between the volatility of risk and the expected returns that are associated with a
portfolio for an individual as well as the inefficient portfolios. The Security Market Line is
the main concept that is used in the Capital Asset Pricing Model. The risk that is associated
with the Security Market Line is presented in terms of beta. Beta is nothing but the security
sensitivity with regards to fluctuations in the market returns. On the other hand, Capital
Market Line is used to represent the risk free rate of return corresponding to an efficient
portfolio. The risk in case of the Capital Market Model is presented in terms of variance or
standard deviation. By standard deviation, it is meant the deviation from the mean value. The
mathematical and graphical representation of the models are provided for a better
understanding of the matter.
Let ( σ m ,rm ¿ be the point corresponding to the market portfolio M and ( σ p , r p ¿be the
point on the capital market line. The equation of the capital market line is denoted by,
r p =rf + r M −r f
σ M
σ p
Where, r p = rate of return of the efficient portfolio and σ p = variance of the expected
portfolio, rM −rf
σ M
is the price of risk as well as the slope of the Capital Market Line.
For any ith individual,
ri−rf =βi(rm−r f ) ,
Where, ri = required rate of return on the ith individual financial asset

2CORPORATE FINANCE MANAGEMENT
r f = risk free rate of return
βi = volatility of the ith individual asset
rm= average return on capital market
The above is the equation of the Security Market Line with β portfolio.
From the two diagrams provided below it can be seen that the Capital Market Line is
the locus of the point of the most efficient portfolio and the risk free rate of returns associated
with that portfolio. The tangent that passes through the efficient portfolio is the Capital Asset
Line. By efficient portfolio it is meant by the combination of the risky and risk free assets
that a person can buy which will maximize the sharp ratio. In Figure 1 the tangent passing
through the most efficient portfolio is the Capital Market Line. In contrast to that the slope of
the Security Market Line shows the volatility of the risk associated to an individual assets or
of all the portfolios which include inefficient ones. The β that is said in the above equation of
the Security Market Line is the major concern. Beta represents the measure of the changes in
security’s sensitivity with respect to that of the market returns and also the slope of the
Security Market Line. Often beta is considered as a more appropriate measure for the security
risk.