Do We Need CAPM for Capital Budgeting?

Jagannathan, Ravi; Meier, Iwan

doi:10.2307/3666174

Cited by 53 publications

(21 citation statements)

References 43 publications

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“…In 2008, CAPM had the highest mean value (1,56) and most companies using it (31%). Even though CAPM has been questioned (Jagannathan and Meier, 2002), it should still be regarded as a more sophisticated method than to ask the investors what they require (Bruner et al, 1998). *** denotes a significant change at the p < 0,01 level.…”

Section: Changes Over Time In Swedish Companies' Use Of Cost-of-equitmentioning

confidence: 99%

The Use Of Capital Budgeting And Cost Of Capital Estimation Methods In Swedish-Listed Companies

Hartwig

2012

JABR

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In this paper Swedish listed companies' use of capital budgeting and cost of capital estimation methods in 2005 and 2008 are examined. The relation between company characteristics and choice of methods is investigated and both within-country longitudinal and cross-country comparisons are made. Larger companies seem to have used capital budgeting methods more frequently than smaller companies. When compared to U.S. and continental European companies, Swedish listed companies employed capital budgeting methods less frequently. In 2005 the most common method for establishing the cost of equity was by asking the investors what return they required. By 2008 CAPM was instead the most utilised method, which could indicate greater sophistication. The use of project risk when evaluating investments also seems to have gained in popularity, while the use of company risk declined. Overall, the use of sophisticated capital budgeting and cost of capital estimation methods seem to be rising and the use of less sophisticated methods declining.Keywords: Capital Budgeting Method; Cost of Equity; Project Risk; Swedish-listed Companies INTRODUCTIONophisticated capital budgeting methods are often "highly recommended" by financial management textbooks, e.g. net present value (NPV), whereas others that are simpler are not, e.g. undiscounted payback (e.g. Brealey and Myers, 2003;Lumby and Jones, 2003;Ross et al., 2005;Smart et al., 2007). Theoretical advice is also given on how to estimate the cost of capital. Estimation models like the capital asset pricing model (CAPM) are frequently referred to and instructions how to calculate project discounts rates, contingent on the underlying risk of the project, instead of using a single company discount rate, are presented (e.g. Brealey and Myers, 2003;Lumby and Jones, 2003;Ross et al., 2005;Smart et al., 2007). Furthermore, multinationals are advised to consider risk factors such as political and foreign exchange risk (Shapiro, 2002;Eiteman et al., 2006). Still, the practical use of economic models can, as earlier research has shown (Graham and Harvey, 2001;Sandahl and Sjögren, 2003;Brounen et al., 2004;Danielson and Scott, 2006), deviate from what is prescribed by normative theory. Management, possibly with other goals than the principal (Jensen and Meckling, 1976), decides whether the recommended methods should be employed or not. The goal incongruence together with the information asymmetry between management and the shareholders, might lead to different practical behaviour than what is recommended by textbooks (Narayanan, 1985). And moreover, also in an ideal world where the principalagent problem does not exist or is limited, there might be a discrepancy between theory and practice. Methods that from a theoretical perspective at first sight have flaws can in practice namely be efficient and lead to shareholder wealth maximisation. Guthrie (1997, 2006) showed, for example, that the employment of the payback method could be rational since the payback time approximates the optio...

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Section: Changes Over Time In Swedish Companies' Use Of Cost-of-equitmentioning

confidence: 99%

The Use Of Capital Budgeting And Cost Of Capital Estimation Methods In Swedish-Listed Companies

Hartwig

2012

JABR

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“…Conventionally, it is assumed 22 (AS.1) too pragmatically that both the risk free rate of interest and the market price of risk are constants over time; denoted and for all periods, . It is hardly crucial assumptions at the present, rather a notional matter of convenience and quite acceptable approximations, although theoretically we can't refuge the variability 23 and the modern flourishing financial econometrics can quite easily handle e. g. time-varying market price of risk, cf. for example M. w. Brandt and Q. w. wang (2003) in another errand than the paper in hand.…”

Section: Capm Basicallymentioning

confidence: 99%

Modification of capital budgeting under uncertainty

Wolffsen¹

2012

AESR

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introductionThe allocation of capital investment is one of the most important and essential corporative decisions. At the present time the company acquires a bunch of real assets and enters a nexus of contracts with its shareholders, creditors, employers, customers, suppliers, and other stakeholders. The company keeps and governs the assets in the future; sometimes the investment concerns a considerable amount of assets measures in physical units and pecuniary units as well, and sometimes the investment concerns a sizeable span of time measured in years, even decades. The risk is that the decision is wrong, and Poul wOlffSEN modification of capital budgeting under uncertaintyThe root purpose is a slight, pragmatic modification of the traditional discounted cash flow mo del of real investment under uncertainty. It is motivated by the occasional inadequacy of the Net Present Value (NPV) analysis with risk. It is done in accordance with the prescribed approach to capital budgeting suggested by the well-known textbooks in corporate finance. The traditional approaches are reviewed shortly. Keywords: Capital budgeting, NPV, risk-adjusted discount factor, certainty equivalence.Pagrindinis io straipsnio tikslas yra atlikti diskontuotų pinigų srautų (realių investicijų) modifikaciją esant neapibrėžtumui. Tai aktualu dėl esamų ir dažnų neatitikimų analizėse, kurios analizuoja dabartinę grynąją vertę (NPV) su rizika. Visa tai atlikta remiantis esamu požiūriu į kapitalo biudžetą, kurį siūlo gerai žinomi įmonių finansų vadovėliai. Straipsnyje apžvelgiami tradiciniai požiūriai. Raktiniai žodžiai: Kapitalo biudžetas, NPV, diskontavimo daugiklis, apibrėžtumo lygiavertiškumas.JEL Classification: G31.

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“…But if risk is not the major determinant of differences in hurdle rates, what is? As noted above, explanations for the observation of hurdle rates higher than the cost of capital is a real-options irreversibility premium (Jagannathan and Meier 2002). Hurdle rates lower than the cost of capital may be explained, as noted above either by lax control and a desire for empire building, or alternatively, by strategic use of follow-on options.…”

Section: Introductionmentioning

confidence: 99%

Why do hurdle rates differ from the cost of capital?

Driver¹,

Temple²

2009

Cambridge Journal of Economics

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Analysing a sample of business units from the PIMS data bank of North American companies we are able to extract data on investment hurdle rates, thus accessing a variable that is rarely observable. The text-book story maintains that firms should invest only if the return exceeds the cost of funds. Several theories however, explain the use of investment hurdle rates that differ from discount rates. We find that hurdle rates are frequently below and also frequently above matched data on discount rates. In a statistical analysis we find that this behaviour can be explained by a combination of agency theory and real options theory. We take this as important evidence that a full explanation of capital investment cannot be accomplished without a consideration of behavioural and strategic influences.

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Do We Need CAPM for Capital Budgeting?

Cited by 53 publications

References 43 publications

The Use Of Capital Budgeting And Cost Of Capital Estimation Methods In Swedish-Listed Companies

The Use Of Capital Budgeting And Cost Of Capital Estimation Methods In Swedish-Listed Companies

Modification of capital budgeting under uncertainty

Why do hurdle rates differ from the cost of capital?

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