Working Paper: NBER ID: w8719
Authors: Ravi Jagannathan; Iwan Meier
Abstract: A key input to the capital budgeting process is the cost of capital. Financial managers most often use the CAPM for estimating the cost of capital for which they need to know the market risk premium. Textbooks advocate using the historical value for the U.S. equity premium as the market risk premium. The CAPM as a model has been seriously challenged in the academic literature. In addition recent research indicates that the true market risk premium might have been as low as half the historical U.S. equity premium during the last two decades. If business finance courses have been teaching the use of the wrong model along with wrong inputs for twenty years, why has no one complained? We provide an answer to this puzzle.
Keywords: CAPM; Capital Budgeting; Cost of Capital; Market Risk Premium
JEL Codes: G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Reliance on the CAPM (G19) | Misestimate the cost of capital (G31) |
| Misestimate the cost of capital (G31) | Affects investment decisions and project evaluations (H43) |
| Use of historical equity premiums as market risk premium (G12) | Overestimate expected returns (G17) |
| Overestimate expected returns (G17) | Higher perceived value of projects (H43) |
| Higher perceived value of projects (H43) | Higher number of projects accepted (H43) |
| Higher number of projects accepted (H43) | Misallocation of capital (E22) |
| CAPM assumptions about market behavior and risk premiums (G40) | Systematic errors in capital budgeting (G31) |