Final answer:
The disadvantages of the Security Market Line (SML) approach include the need to estimate the market risk premium and the security's beta. However, not requiring a company to pay a dividend is not a disadvantage, and adjusting for risk is actually an advantage of the SML approach.
Step-by-step explanation:
The SML approach, or Security Market Line approach, is a concept derived from the Capital Asset Pricing Model (CAPM). It is a graphical representation of the expected return of investments as a function of their risk, as measured by beta. The SML reflects the relationship between risk and return for all securities in the market.
Disadvantages of using the SML approach include:
- Requires estimation of the market risk premium: This involves predicting future market returns, which can be uncertain and requires historical data.
- Requires estimation of beta: Estimating beta for a security can be difficult, especially for new companies or those without a clear market comparison.
- Does not require the company to pay a dividend: The SML can be applied to companies that do not pay dividends, which is an advantage in some cases but does not relate to the company's cost of equity if it does pay dividends.
- Adjusts for risk: This is actually a benefit of the SML, as it allows investors to compare returns of investments with different levels of risk.