Corporate Investment Criteria and the Valuation of Risk Assets

Journal of Property Investment &Amp; Finance

2008

PurposeIn investment decision making, the net present value (NPV) rule is often used alongside the well‐known capital asset pricing model (CAPM). In particular, the use of disequilibrium NPV is endorsed in corporate finance for both valuation and decision. The purpose of this paper is to test the reliability of this approach to capital budgeting valuations and decisions.Design/methodology/approachThe use of disequilibrium values for computing a project's NPV is considered, and the consistency with the CAPM is checked. The resulting valuation and decision are contrasted with the no‐arbitrage principle, which is universally considered a benchmark for rationality.FindingsThe paper finds that the disequilibrium NPV is logically deducted from the CAPM for decision‐making purposes. However, this NPV provides nonadditive values, which makes it inconsistent with the no‐arbitrage principle.Practical implicationsThe use of the CAPM+NPV procedure for valuing projects is invalid if disequilibrium values are used. Its use for decision making is logically valid but practically unsafe, because decision makers may frame equivalent courses of action in different ways, resulting in different decisions, which implies that they may incur arbitrage losses.Originality/valueThe literature does not distinguish between equilibrium and disequilibrium NPV nor between valuation and decision. This paper explicitly makes this distinction and the resulting consequences are highlighted.

Section: Equivalent Mean-variance Capital Budgeting Criteriamentioning

confidence: 68%

CAPM‐based capital budgeting and nonadditivity

Journal of Property Investment &Amp; Finance

2008

“…These criteria are actually equivalent to Rubinstein's (and therefore equivalent one another). In particular, Litzenberger and Budd (1970) acknowledge the equivalence of the criteria proposed by Tuttle and Litzenberger, Hamada, and Mossin. Stapleton (1974) recognizes that his own criterion is equivalent to that proposed by Bierman and Hass (see also Bierman and Hass, 1974).…”

Section: The Use Of the Capm For Investment Decisionsmentioning

confidence: 94%

Theoretical Flaws in the Use of the CAPM For Investment Decisions

2005

SSRN Journal

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.

“…Among these authors, we find Tuttle and Litzenberger (1968), Mossin (1969), Hamada (1969), Litzenberger and Budd (1970), Rubinstein (1973), Hass (1973, 1974), Stapleton (1971Stapleton ( , 1974, Bogue and Roll (1974). 7 Although these authors are never explicit about this issue, an analysis of some of their papers seems to be supportive of the disequilibrium NPV.…”

mentioning

confidence: 91%

“…For example, Tuttle and Litzenberger (1968), Hamada (1969), Litzenberger and Budd (1970), Rubinstein (1973) directly and explicitly focus on the notion of cost of capital. They all prove that a project is worth undertaking if its expected rate of return exceeds the risk-adjusted cost of capital (which depends on the project cost, not on the project's equilibrium value).…”

mentioning

confidence: 99%

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

European Journal of Operational Research

2009

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 (2002Magni's ( , 2007a