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CAPM‐based capital budgeting and nonadditivity

CAPM‐based capital budgeting and nonadditivity Purpose – In investment decision making, the net present value (NPV) rule is often used alongside the well‐known capital asset pricing model (CAPM). In particular, the use of disequilibrium NPV is endorsed in corporate finance for both valuation and decision. The purpose of this paper is to test the reliability of this approach to capital budgeting valuations and decisions. Design/methodology/approach – The use of disequilibrium values for computing a project's NPV is considered, and the consistency with the CAPM is checked. The resulting valuation and decision are contrasted with the no‐arbitrage principle, which is universally considered a benchmark for rationality. Findings – The paper finds that the disequilibrium NPV is logically deducted from the CAPM for decision‐making purposes. However, this NPV provides nonadditive values, which makes it inconsistent with the no‐arbitrage principle. Practical implications – The use of the CAPM+NPV procedure for valuing projects is invalid if disequilibrium values are used. Its use for decision making is logically valid but practically unsafe, because decision makers may frame equivalent courses of action in different ways, resulting in different decisions, which implies that they may incur arbitrage losses. Originality/value – The literature does not distinguish between equilibrium and disequilibrium NPV nor between valuation and decision. This paper explicitly makes this distinction and the resulting consequences are highlighted. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Property Investment & Finance Emerald Publishing

CAPM‐based capital budgeting and nonadditivity

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Publisher
Emerald Publishing
Copyright
Copyright © 2008 Emerald Group Publishing Limited. All rights reserved.
ISSN
1463-578X
DOI
10.1108/14635780810900251
Publisher site
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Abstract

Purpose – In investment decision making, the net present value (NPV) rule is often used alongside the well‐known capital asset pricing model (CAPM). In particular, the use of disequilibrium NPV is endorsed in corporate finance for both valuation and decision. The purpose of this paper is to test the reliability of this approach to capital budgeting valuations and decisions. Design/methodology/approach – The use of disequilibrium values for computing a project's NPV is considered, and the consistency with the CAPM is checked. The resulting valuation and decision are contrasted with the no‐arbitrage principle, which is universally considered a benchmark for rationality. Findings – The paper finds that the disequilibrium NPV is logically deducted from the CAPM for decision‐making purposes. However, this NPV provides nonadditive values, which makes it inconsistent with the no‐arbitrage principle. Practical implications – The use of the CAPM+NPV procedure for valuing projects is invalid if disequilibrium values are used. Its use for decision making is logically valid but practically unsafe, because decision makers may frame equivalent courses of action in different ways, resulting in different decisions, which implies that they may incur arbitrage losses. Originality/value – The literature does not distinguish between equilibrium and disequilibrium NPV nor between valuation and decision. This paper explicitly makes this distinction and the resulting consequences are highlighted.

Journal

Journal of Property Investment & Finance – Emerald Publishing

Published: Aug 8, 2008

Keywords: Investments; Net present value; Economic disequilibrium; Capital asset pricing model; Project evaluation; Decision making

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