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CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence

  • Zhi Da
  • Re-Jin Guo
  • Ravi Jagannathan

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. Since stocks are backed not only by projects in place, but also 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14889.

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Date of creation: Apr 2009
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Publication status: published as Journal of Financial Economics Volume 103, Issue 1, January 2012, Pages 204–220 Cover image CAPM for estimating the cost of equity capital: Interpreting the empirical evidence ☆ Zhi Daa, 1, E-mail the corresponding author, Re-Jin Guob, 2, E-mail the corresponding author, Ravi Jagannathanc, d,
Handle: RePEc:nbr:nberwo:14889
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