Working Paper: NBER ID: w14889
Authors: Zhi Da; Rejin Guo; Ravi Jagannathan
Abstract: We argue that the empirical evidence against the Capital Asset Pricing Model (CAPM) based on stock returns does not invalidate its use for estimating the cost of capital for projects in making capital budgeting decisions. Since stocks are backed not only by projects in place, but also the options to modify current projects and undertake new ones, the expected returns on stocks need not satisfy the CAPM even when expected returns of projects do. We provide empirical support for our arguments by developing a method for estimating firms' project CAPM-betas and project returns. Our findings justify the continued use of the CAPM by firms in spite of the mounting evidence against it based on the cross-section of stock returns.
Keywords: CAPM; Cost of Capital; Project Evaluation; Real Options
JEL Codes: G00; G11; G12; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CAPM remains valid for estimating the cost of capital for projects (H43) | fails in predicting stock returns (G17) |
| CAPM can accurately estimate project betas and returns (G17) | adjusted for real options (D25) |
| real option adjustments (D25) | explanatory power of the CAPM (G11) |
| CAPM beta (C46) | excess stock returns (G12) |
| CAPM (O22) | cross-section of average excess returns (G12) |