Summary

CAPM and capital budgeting The objective of the present paper is to discuss the efficacy of the Capital Asset Pricing Model (CAPM) in the context of capital budgeting by firms. In particular the merit of the arguments put forward by Jagannathan and Meier (2002) in the article titled “Do we need CAPM for capital budgeting” shall be evaluated in the context of relevant literature… Read TextPreview

- Subject: Macro & Microeconomics
- Type: Essay
- Level: College
- Pages: 3 (750 words)
- Downloads: 1
- Author: lstamm

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The estimation of the cost of capital in turn is based upon the CAPM. However, not only does recent discourses in academic literature challenge the validity of the CAPM model, there is lack of consensus regarding the adequate measure of the market risk premium, a central input required for computing the cost of capital using the CAPM. However, in spite of these short comings, the CAPM has survived as the predominant quantitative model in its class for over 40 years since its inception. It is precisely this paradox the paper in concern addresses. In particular, Jagannathan and Meler (2002) offer an explanation to the following question: in spite of the various short comings of the CAPM model in computing the cost of capital, why do majority of managers report using the model to make critical decisions? The answer they offer is that in the real world, computing the exact cost of capital may not be crucial for optimal decisions. Hence, although the CAPM may not provide the exact value of cost of capital, but it still remains useful for managers. Assuming rationed organizational and managerial capital which implies that not all projects with positive NPVs can be invested in, the paper shows that utilizing a hurdle rate greater than the cost of capital and the typical NPV computations, the value of waiting for an option can be accounted for. Therefore, the exact value of cost of capital no longer remains an imperative for optimal decisions. The idea that discounting values are set much higher than the cost of capital has significant support in financial literature. Stein (2001) for instance shows that aspects like agency costs arising out of asymmetric informational situations among share owners and managers leads to setting of discount rates that are much higher than the actual cost of capital. Empirical literature also lends further support to the claim by establishing the existence of a large number of hurdle rates that are set higher than the cost of capital (Poterba and Summers, 1995). Truong, Partington and Peat (2008) have also established that there are a number of hurdle rates used in the capital budgeting procedure in Australia. The critiques of using CAPM in capital budgeting fundamentally stem from two particular difficulties. First, the time horizon of the basic model is limited to a single period. But in reality, investment appraisals of firms typically involve decision making over multiple periods. Thus, this raises the question of applicability of the CAPM in investment appraisal in the real world. Secondly, computing discount rates specific to particular projects can prove difficult owing to for instance, difficulties arising in identification of appropriate proxy betas as proxy companies usually undertake multiple activities simultaneously. Disentangling the beta specific to a project may prove near impossible because these require certain information that may be extremely difficult to obtain. (Head, 2008) Additionally, it has been shown that although the NPV criterion can be utilized to make accept/reject decisions, these are valid and optimal only if the discount rate is not computed using the CAPM (Magni, 2009). In light of the discussion above what emerges essentially is that the CAPM generates estimates of cost of capital
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