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Theoretical Flaws In The Use Of The Capm For Investment Decisions

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  • Magni, Carlo Alberto

Abstract

This paper uses counterexamples and simple formalization to show that the standard CAPM-based Net Present Value may not be used for investment valuations. The reason is that the standard CAPM-based capital budgeting criterion implies a notion of value which does not comply with the principle of additivity. Framing effects arise in decisions so that different descriptions of the same problem lead to different choices. As a result, the CAPM-based NPV as a tool for valuing projects and making investment decisions is theoretically unsound, even if the CAPM assumptions are met.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 6330.

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Date of creation: Dec 2005
Date of revision: Nov 2007
Handle: RePEc:pra:mprapa:6330

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Keywords: Capital budgeting; CAPM; investment decisions; nonadditivity; framing effects;

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  1. Magni, Carlo Alberto, 2002. "Investment decisions in the theory of finance: Some antinomies and inconsistencies," European Journal of Operational Research, Elsevier, Elsevier, vol. 137(1), pages 206-217, February.
  2. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, Elsevier, vol. 60(2-3), pages 187-243, May.
  3. Stapleton, Richard C, 1974. "Capital Budgeting under Uncertainty: A Reformation: Comment," Journal of Finance, American Finance Association, American Finance Association, vol. 29(5), pages 1583-84, December.
  4. Magni, Carlo Alberto, 2007. "CAPM and capital budgeting: present versus future, equilibrium versus disequilibrium, decision versus valuation," MPRA Paper 5468, University Library of Munich, Germany.
  5. Magni, Carlo Alberto, 2009. "Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM?," European Journal of Operational Research, Elsevier, Elsevier, vol. 192(2), pages 549-560, January.
  6. Carlo Alberto Magni, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," Applied Financial Economics Letters, Taylor and Francis Journals, Taylor and Francis Journals, vol. 3(2), pages 137-140.
  7. Bierman, Harold, Jr & Hass, Jerome E, 1973. "Capital Budgeting Under Uncertainty: A Reformulation," Journal of Finance, American Finance Association, American Finance Association, vol. 28(1), pages 119-29, March.
  8. John Graham & Campbell Harvey, 2002. "HOW DO CFOs MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS?," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 15(1), pages 8-23.
  9. Fama, Eugene F., 1977. "Risk-adjusted discount rates and capital budgeting under uncertainty," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(1), pages 3-24, August.
  10. Ravi Jagannathan & Iwan Meier, 2002. "Do We Need CAPM for Capital Budgeting?," NBER Working Papers 8719, National Bureau of Economic Research, Inc.
  11. Ekern, Steinar, 2006. "A Dozen Consistent CAPM-Related Valuation Models - So Why Use the Incorrect One?," Discussion Papers, Department of Business and Management Science, Norwegian School of Economics 2006/6, Department of Business and Management Science, Norwegian School of Economics, revised 25 Apr 2007.
  12. Dybvig, Philip H & Ingersoll, Jonathan E, Jr, 1982. "Mean-Variance Theory in Complete Markets," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 55(2), pages 233-51, April.
  13. Bogue, Marcus C & Roll, Richard, 1974. "Capital Budgeting of Risky Projects with "Imperfect" Markets for Physical Capital," Journal of Finance, American Finance Association, American Finance Association, vol. 29(2), pages 601-13, May.
  14. Mossin, Jan, 1969. "Security Pricing and Investment Criteria in Competitive Markets," American Economic Review, American Economic Association, American Economic Association, vol. 59(5), pages 749-56, December.
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