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CAPM for estimating the cost of equity capital: Interpreting the empirical evidence

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  • Da, Zhi
  • Guo, Re-Jin
  • Jagannathan, Ravi

Abstract

We argue that the empirical evidence against the capital asset pricing model (CAPM) based on stock returns does not invalidate its use for estimating the cost of capital for projects in making capital budgeting decisions. Because stocks are backed not only by projects in place, but also by the options to modify current projects and undertake new ones, the expected returns on stocks need not satisfy the CAPM even when expected returns of projects do. We provide empirical support for our arguments by developing a method for estimating firms' project CAPM betas and project returns. Our findings justify the continued use of the CAPM by firms in spite of the mounting evidence against it based on the cross section of stock returns.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 103 (2012)
Issue (Month): 1 ()
Pages: 204-220

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Handle: RePEc:eee:jfinec:v:103:y:2012:i:1:p:204-220

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Web page: http://www.elsevier.com/locate/inca/505576

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Keywords: CAPM; Asset pricing anomalies; Cost of capital; Beta; Capital budgeting;

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Cited by:
  1. Chengru Hu & Wei Jiang & Cheng-few Lee, 2013. "Managerial flexibility and the wealth effect of new product introductions," Review of Quantitative Finance and Accounting, Springer, vol. 41(2), pages 273-294, August.
  2. Hamid Reza Vakilifard & Nassim Shahmoradi, 2014. "Investigating the Effects of Stable Profitability and Free Cash Flow on Stock Returns of Companies Listed in Tehran Stock Exchange," International Journal of Academic Research in Accounting, Finance and Management Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Accounting, Finance and Management Sciences, vol. 4(3), pages 21-27, July.
  3. Jing Yang & Kostas Tsatsaronis, 2012. "Bank stock returns, leverage and the business cycle," BIS Quarterly Review, Bank for International Settlements, March.
  4. Ai, Hengjie & Kiku, Dana, 2013. "Growth to value: Option exercise and the cross section of equity returns," Journal of Financial Economics, Elsevier, vol. 107(2), pages 325-349.
  5. Lund, Diderik & Nymoen, Ragnar, 2013. "Comparative statics for real options on oil: What stylized facts to use?," Memorandum 14/2013, Oslo University, Department of Economics.

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