Final answer:
The SML approach helps in estimating expected returns without needing a company to pay a dividend, using beta for gauging risk, and adjusting returns for risk with a market risk premium, although real-world profit estimates and discount rates require careful consideration.option B is correct answer.
Step-by-step explanation:
The student appears to be inquiring about the advantages of using the Security Market Line (SML) approach in evaluating investments. The SML, which is part of the Capital Asset Pricing Model (CAPM), offers several benefits in determining the expected returns of a stock or portfolio based on its risk level. Firstly, one advantage of the SML approach is that it does not require a company to pay a dividend, making it applicable for companies that reinvest earnings instead of distributing them.
Additionally, the SML relies on the estimation of beta, a measure of systemic risk that indicates how much the investment's returns may fluctuate in response to market movement. Lastly, the inclusion of a market risk premium in the SML formula measures the extra return investors demand for taking on higher risk compared to a risk-free investment. This market risk premium can vary over time and adjust for differing levels of perceived risk, ensuring that the expected return reflects current market sentiments.
While this approach has several advantages, in the real world, estimating expected profits requires making assumptions and predictions that may not always accurately reflect future performance. The selection of an appropriate discount rate for Present Discounted Value calculations is particularly challenging, as it involves forecasting potential capital gains and expected dividends.
However, these variations in opinion about an investment's prospects are what drive market dynamics, with some investors more optimistic about future returns than others.