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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 (2002, 2007a, forthcoming) criticism of the NPV criterion refers to the disequilibrium NPV, and De Reyck’s (2005) 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

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5471.

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Date of creation: 2007
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Handle: RePEc:pra:mprapa:5471

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Keywords: Corporate 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. Magni, Carlo Alberto, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," MPRA Paper 14525, University Library of Munich, Germany.
  2. 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.
  3. Magni, Carlo Alberto, 2007. "Project selection and equivalent CAPM-based investment criteria," MPRA Paper 14526, University Library of Munich, Germany.
  4. Fama, Eugene F, 1996. "Discounting under Uncertainty," The Journal of Business, University of Chicago Press, vol. 69(4), pages 415-28, October.
  5. 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.
  6. 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.
  7. 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.
  8. Mossin, Jan, 1969. "Security Pricing and Investment Criteria in Competitive Markets," American Economic Review, American Economic Association, vol. 59(5), pages 749-56, December.
  9. Magni, Carlo Alberto, 2006. "CAPM-based capital budgeting and nonadditivity," MPRA Paper 7290, University Library of Munich, Germany.
  10. 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.
  11. 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.
  12. Stapleton, Richard C, 1974. "Capital Budgeting under Uncertainty: A Reformation: Comment," Journal of Finance, American Finance Association, vol. 29(5), pages 1583-84, December.
  13. Hamada, Robert S, 1969. "Portfolio Analysis, Market Equilibrium and Corporation Finance," Journal of Finance, American Finance Association, vol. 24(1), pages 13-31, March.
  14. 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.
  15. Benninga, Simon, 2006. "Principles of Finance with Excel," OUP Catalogue, Oxford University Press, number 9780195301502.
  16. Lewellen, Wilbur G, 1977. "Some Observations on Risk-Adjusted Discount Rates," Journal of Finance, American Finance Association, vol. 32(4), pages 1331-37, September.
  17. 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.
  18. 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.
  19. 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.
  20. 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.
  21. 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.
  22. 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.
  23. 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.
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Cited by:
  1. 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.
  2. Magni, Carlo Alberto, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," MPRA Paper 14525, University Library of Munich, Germany.
  3. 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.
  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.

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