Firm Value and the Mis-Use of the CAPM for Valuation and Decision Making

Abstract

Abstract.The use of CAPM-based disequilibrium betas and Net Present Value (NPV) for investment decisions and valuations is widespread in finance. Actually, its use is logically deducted from the CAPM assumptions. This paper deals with decisions about purchase of a firm and the related issue of firm valuation. In particular, it contrasts disequilibrium betas and NPVs with Modigliani and Miller's Proposition I, and shows that disequilibrium betas and NPVs should not be used because they lead to irrational valuations and unreliable decisions; in particular, they lead decision makers to infringe Modigliani and Miller's Proposition I. To prove the thesis, a counterexample is shown where two firms with same expected free cash flows are valued, one of which is levered, the other one is unlevered. A formal generalization is also provided. The results indicate that the use of disequilibrium NPV should be avoided, because valuations are incorrect and decisions are unsafe, leaving decision makers open to framing effects and arbitrage losses.

Prediction of Stock Prices Using Capital Asset Pricing Model in Nigerian Stock Market

“…The research method employed is quantitative method, which is unlike qualitative, as a way of assessing the stock price .The most effective methods for determining the stock return have been the subject of extensive research (Paul & Asarebea, 2015). While the majority of research (Magni, 2005;Fama & French, 2004) agree that using CAPM is an essential application area of finance for stock valuations and investment decisions, they disagree on relative advantages of the CAPM and the APT model. The CAPM's rigid assumptions and incapacity to be empirically tested are cited by those who favor the APT model (Harrington & Korajczyk, 1993;Nel & Nel, 2011).…”