Taxes change investors’ return expectations. Considering different marginal tax rates will result in a vast array of different after-tax requirements, leading to a vast array of CMLs and SMLs for different investors. The assumption of no transaction costs allows investors to make a profit even if a stock is just slightly off the SML. If risk-free borrowing and lending does not exist, then a portfolio of risky securities must be created such that the portfolio beta equals zero. The zero-beta portfolio is similar to the risk-free asset in that both have zero betas, but they differ in that the zero-beta portfolio has a non-zero standard deviation. The expected return on the zero-beta portfolio exceeds the risk-free rate therefore the SML will now have a higher intercept and a flatter slope |
