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Relaxing the Assumptions 259

EXHIBIT 8.16^ SECURITY MARKET LINE WITH TRANSACTION COSTS

Heterogeneous If all investors had different expectations about risk and return, each would have a unique CML Expectations and and/or SML, and the composite graph would be a set (band) of lines with a breadth determined Planning Periods by the divergence of expectations. If all investors had similar information and background, the band would be reasonably narrow.

The impact of planning periods is similar. Recall that the CAPM is a one-period model, corresponding to the planning period for the individual investor. Thus, if you are using a one-year planning period, your CML and SML could differ from mine, which assumes a one-month planning period.

Taxes The rates of return that we normally record and that were used throughout the model were pretax returns. In fact, the actual returns for most investors are affected as follows:

(Pe - Pb) x (1 - Tcg) + (Div) x (1 - T) >8.9 E (Ri)(AT) = —---—--

where:

Ri(AT) = after-tax rate of return

Pe = ending price

Pb = beginning price

Tcg = tax on capital gain or loss

Div = dividend paid during period

Ti = tax on ordinary income

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