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

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Magni, Carlo Alberto

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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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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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Related research
Keywords: Corporate finance; investment analysis; Net Present Value; Capital Asset Pricing Model; disequilibrium; decision; valuation; nonadditivity; arbitrage.;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Fama, Eugene F, 1996. "Discounting under Uncertainty," Journal of Business, University of Chicago Press, vol. 69(4), pages 415-28, October. [Downloadable!] (restricted)
  2. Stapleton, Richard C, 1974. "Capital Budgeting under Uncertainty: A Reformation: Comment," Journal of Finance, American Finance Association, vol. 29(5), pages 1583-84, December. [Downloadable!] (restricted)
  3. Bondonio, Daniele, 2002. "Evaluating the Employment Impact of Business Incentive Programs in EU Disadvantaged Areas. A case from Northern Italy," P.O.L.I.S. department's Working Papers 27, Department of Public Policy and Public Choice - POLIS. [Downloadable!]
  4. 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. [Downloadable!] (restricted)
  5. Lewellen, Wilbur G, 1977. "Some Observations on Risk-Adjusted Discount Rates," Journal of Finance, American Finance Association, vol. 32(4), pages 1331-37, September. [Downloadable!] (restricted)
  6. Magni, Carlo Alberto, 2006. "CAPM-based capital budgeting and nonadditivity," MPRA Paper 6606, University Library of Munich, Germany. [Downloadable!]
  7. 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. [Downloadable!] (restricted)
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  8. 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.
  9. 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. [Downloadable!]
  10. 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. [Downloadable!] (restricted)
  11. 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. [Downloadable!] (restricted)
  12. Brounen, D. & Jong, A. de & Koedijk, C.G., 2004. "Corporate Finance In Europe Confronting Theory With Practice," Research Paper ERS-2004-002-F&A Revision, 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. [Downloadable!]
  13. 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. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Magni, Carlo Alberto, 2005. "Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I," MPRA Paper 6359, University Library of Munich, Germany, revised 22 Jun 2008. [Downloadable!]
  2. Carlo Alberto, Magni, 2008. "Splitting Up Value: A Critical Review of Residual Income Theories," MPRA Paper 10506, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  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. [Downloadable!]
  4. Magni, Carlo Alberto, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," MPRA Paper 14525, University Library of Munich, Germany. [Downloadable!]
    Other versions:
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