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Theoretical Flaws In The Use Of The Capm For Investment Decisions

  • Magni, Carlo Alberto

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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File URL: http://mpra.ub.uni-muenchen.de/6330/1/MPRA_paper_6330.pdf
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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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  1. Fama, Eugene F., 1977. "Risk-adjusted discount rates and capital budgeting under uncertainty," Journal of Financial Economics, Elsevier, vol. 5(1), pages 3-24, August.
  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.
  3. Magni, Carlo Alberto, 2007. "Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM?," MPRA Paper 5471, University Library of Munich, Germany.
  4. 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.
  5. Dybvig, Philip H & Ingersoll, Jonathan E, Jr, 1982. "Mean-Variance Theory in Complete Markets," The Journal of Business, University of Chicago Press, vol. 55(2), pages 233-51, April.
  6. 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.
  7. 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.
  8. Ravi Jagannathan & Iwan Meier, 2002. "Do We Need CAPM for Capital Budgeting?," NBER Working Papers 8719, National Bureau of Economic Research, Inc.
  9. 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.
  10. Magni, Carlo Alberto, 2007. "Project valuation and investment decisions: CAPM versus arbitrage," MPRA Paper 14525, University Library of Munich, Germany.
  11. 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.
  12. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
  13. 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.
  14. Mossin, Jan, 1969. "Security Pricing and Investment Criteria in Competitive Markets," American Economic Review, American Economic Association, vol. 59(5), pages 749-56, December.
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