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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?

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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.

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  • $\begingroup$ so for all the project that a company takes on, the required rate of return is simply based on the expected return on the share and/or the interest rate on money borrowed for the project? $\endgroup$ – Sazid Ahmad Feb 28 '16 at 17:39
  • $\begingroup$ @Sazid_violin I have explicitly written my answer, CAPM provide minimum expected return expected by shareholders. Expected return on projects depends on various factors, like uncertainly with the cash flow, risk in the project undertaken, etc. $\endgroup$ – Neeraj Feb 28 '16 at 18:07
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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.

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