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Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM?

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  • Magni, Carlo Alberto

Abstract

This paper focuses on inconsistencies arising from the use of NPV and CAPM for capital budgeting. It shows that: (i) CAPM capital budgeting decision-making based on disequilibrium NPV is deductively inferred by the capital asset pricing model, (ii) the use of the disequilibrium NPV is widespread in finance both as a decision rule and as a valuation tool, (iii) the disequilibrium NPV does not guarantee additivity nor consistency with arbitrage pricing, so that it is unreliable for valuation, (iv) Magni's [Magni, C.A., 2002. Investment decisions in the theory of finance: Some antinomies and inconsistencies. European Journal of Operational Research 137, 206-217; Magni, C.A., 2007a. Project valuation and investment decisions: CAPM versus arbitrage. Applied Financial Economics Letters 3 (2), 137-140] criticism of the NPV criterion refers to the disequilibrium NPV, and De Reyck's [De Reyck, B., 2005. On investment decisions in the theory of finance: Some antinomies and inconsistencies. European of Operational Research 161, 499-504] project valuation method, on the basis of which Magni's criticism to NPV is objected, leaves decision makers open to arbitrage losses and incorrect decisions.

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Bibliographic Info

Article provided by Elsevier in its journal European Journal of Operational Research.

Volume (Year): 192 (2009)
Issue (Month): 2 (January)
Pages: 549-560

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Handle: RePEc:eee:ejores:v:192:y:2009:i:2:p:549-560

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Web page: http://www.elsevier.com/locate/eor

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Keywords: Finance Investment analysis Net present value Capital asset pricing model Disequilibrium Decision Valuation Nonadditivity Arbitrage;

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References

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  1. Ekern, Steinar, 2006. "A Dozen Consistent CAPM-Related Valuation Models - So Why Use the Incorrect One?," Discussion Papers 2006/6, Department of Business and Management Science, Norwegian School of Economics, revised 25 Apr 2007.
  2. Benninga, Simon, 2006. "Principles of Finance with Excel," OUP Catalogue, Oxford University Press, number 9780195301502.
  3. Magni, Carlo Alberto, 2007. "Project selection and equivalent CAPM-based investment criteria," MPRA Paper 14526, University Library of Munich, Germany.
  4. Brounen, D. & de Jong, A. & Koedijk, C.G., 2004. "Corporate Finance In Europe Confronting Theory With Practice," ERIM Report Series Research in Management ERS-2004-002-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
  5. Fama, Eugene F, 1996. "Discounting under Uncertainty," The Journal of Business, University of Chicago Press, vol. 69(4), pages 415-28, October.
  6. Donald L. Tuttle & Robert H. Litzenberger, 1968. "Leverage, Diversification And Capital Market Effects On A Risk‐Adjusted Capital Budgeting Framework," Journal of Finance, American Finance Association, vol. 23(3), pages 427-443, 06.
  7. John Graham & Campbell Harvey, 2002. "HOW DO CFOs MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS?," Journal of Applied Corporate Finance, Morgan Stanley, vol. 15(1), pages 8-23.
  8. Haley, Charles W. & Schall, Lawrence D., 1978. "Problems with the Concept of the Cost of Capital," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(05), pages 847-870, December.
  9. Rubinstein, Mark E, 1973. "A Mean-Variance Synthesis of Corporate Financial Theory," Journal of Finance, American Finance Association, vol. 28(1), pages 167-81, March.
  10. Carlo Alberto Magni, 2009. "The use of Npv and CAPM for capital budgeting is not a good idea. A reply to De Reyck (2005)," PROYECCIONES FINANCIERAS Y VALORACION 005546, MASTER CONSULTORES.
  11. Hamada, Robert S, 1969. "Portfolio Analysis, Market Equilibrium and Corporation Finance," Journal of Finance, American Finance Association, vol. 24(1), pages 13-31, March.
  12. Litzenberger, Robert H. & Budd, Alan P., 1970. "Corporate Investment Criteria and the Valuation of Risk Assets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 5(4-5), pages 395-419, December.
  13. Bierman, Harold, Jr & Hass, Jerome E, 1973. "Capital Budgeting Under Uncertainty: A Reformulation," Journal of Finance, American Finance Association, vol. 28(1), pages 119-29, March.
  14. Stapleton, Richard C, 1974. "Capital Budgeting under Uncertainty: A Reformation: Comment," Journal of Finance, American Finance Association, vol. 29(5), pages 1583-84, December.
  15. Bogue, Marcus C & Roll, Richard, 1974. "Capital Budgeting of Risky Projects with "Imperfect" Markets for Physical Capital," Journal of Finance, American Finance Association, vol. 29(2), pages 601-13, May.
  16. Carlo Alberto Magni, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," Applied Financial Economics Letters, Taylor and Francis Journals, vol. 3(2), pages 137-140.
  17. Magni, Carlo Alberto, 2002. "Investment decisions in the theory of finance: Some antinomies and inconsistencies," European Journal of Operational Research, Elsevier, vol. 137(1), pages 206-217, February.
  18. Stapleton, Richard C, 1971. "Portfolio Analysis, Stock Valuation and Capital Budgeting Decision Rules for Risky Projects," Journal of Finance, American Finance Association, vol. 26(1), pages 95-117, March.
  19. Magni, Carlo Alberto, 2006. "CAPM-based capital budgeting and nonadditivity," MPRA Paper 7290, University Library of Munich, Germany.
  20. De Reyck, Bert, 2005. "On "investment decisions in the theory of finance: Some antinomies and inconsistencies"," European Journal of Operational Research, Elsevier, vol. 161(2), pages 499-504, March.
  21. Lewellen, Wilbur G, 1977. "Some Observations on Risk-Adjusted Discount Rates," Journal of Finance, American Finance Association, vol. 32(4), pages 1331-37, September.
  22. Mossin, Jan, 1969. "Security Pricing and Investment Criteria in Competitive Markets," American Economic Review, American Economic Association, vol. 59(5), pages 749-56, December.
  23. Dirk Brounen & Abe de Jong & Kees Koedijk, 2004. "Corporate Finance in Europe: Confronting Theory with Practice," Financial Management, Financial Management Association, vol. 33(4), Winter.
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Citations

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Cited by:
  1. Magni, Carlo Alberto, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," MPRA Paper 14525, University Library of Munich, Germany.
  2. Magni, Carlo Alberto, 2009. "Splitting up value: A critical review of residual income theories," European Journal of Operational Research, Elsevier, vol. 198(1), pages 1-22, October.
  3. Magni, Carlo Alberto, 2013. "Generalized Makeham’s formula and economic profitability," Insurance: Mathematics and Economics, Elsevier, vol. 53(3), pages 747-756.
  4. Magni, Carlo Alberto, 2005. "Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I," MPRA Paper 7359, University Library of Munich, Germany, revised 27 Feb 2008.
  5. Magni, Carlo Alberto, 2005. "Theoretical Flaws In The Use Of The Capm For Investment Decisions," MPRA Paper 6330, University Library of Munich, Germany, revised Nov 2007.

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