What would you recommend to an investor who is considering an investment which,

Question

What would you recommend to an investor who is considering an investment which, according to its beta, plots above the security market line (SML)?

a) Invest; return is high relative to risk.
b) Don't invest; risk is high relative to return.
c) Invest; stocks above the SML have very little market risk.
d) Don't invest; stocks above the SML have too much unique risk.

When calculating a project's payback period, cash flows are discounted at:

a) the opportunity cost of capital.
b) the internal rate of return.
c) the risk-free rate of return.
d) a discount rate of zero.

Explanation / Answer

(1) (a)

When an asset plots above the SML, its expected return is higher than the market return, therefore return is higher relative to risk level. This is possible when Beta exceeds 1.

(2) (d)

Payback period is computed using cash flows discounted at zero discount rate, i.e. cash flows are undiscounted. Only when we use Discounted payback period, we discount the cash flows at opportunity cost of capital.

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