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Capital Budgeting in Arbitrage-Free Markets

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  • Laitenberger, Jörg
  • Löffler, Andreas

Abstract

In capital budgeting problems future cash flows are discounted using the expected one period returns of the investment. In this paper we establish a theory that relates this approach to the assumption that markets are free of arbitrage. Our goal is to uncover implicit assumptions on the set of cash flow distributions that are suitable for the capital budgeting method. As results we obtain that the set of admissible cash flow distributions is large in the sense that no particular structure of the evolution of the distributions is implied. We give stylized examples that demonstrate that even strong assumptions on the return distributions do not restrain the shape of the cash flow distributions. In a subsequent analysis we characterize the cash flow distributions under the additional assumption of a deterministic dividend yield. In this case strong properties for the evolution of the distributions can be obtained.

Suggested Citation

  • Laitenberger, Jörg & Löffler, Andreas, 2002. "Capital Budgeting in Arbitrage-Free Markets," Hannover Economic Papers (HEP) dp-258, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    • Handle: RePEc:han:dpaper:dp-258
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    File URL: http://diskussionspapiere.wiwi.uni-hannover.de/pdf_bib/dp-258.pdf
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    References listed on IDEAS

    as
    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Franke, Gunter, 1984. "Conditions for Myopic Valuation and Serial Independence of the Market Excess Return in Discrete Time Models," Journal of Finance, American Finance Association, vol. 39(2), pages 425-442, June.
    3. Geske, Robert, 1978. "The Pricing of Options with Stochastic Dividend Yield," Journal of Finance, American Finance Association, vol. 33(2), pages 617-625, May.
    4. Fama, Eugene F, 1996. "Discounting under Uncertainty," The Journal of Business, University of Chicago Press, vol. 69(4), pages 415-428, October.
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    Cited by:

    1. Laitenberger, Jörg, 2004. "Rendite und Kapitalkosten," Hannover Economic Papers (HEP) dp-295, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.

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    More about this item

    Keywords

    cost of capital; capital budgeting;

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • D46 - Microeconomics - - Market Structure, Pricing, and Design - - - Value Theory

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