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THEORETICAL FLAWS IN THE USE OF THE CAPM FOR INVESTMENT DECISIONS

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Keywords
  • G12 - Asset Pricing
  • Trading Volume
  • Bond Interest Rates
  • G11 - Portfolio Choice
  • Investment Decisions
  • G31 - Capital Budgeting
  • Fixed Investment And Inventory Studies
  • Capacity
  • G30 - General

Abstract

This paper uses counterexamples and simple formalization to show that the standard CAPM-based Net Present Value may not be used for investment valuations. The reason is that the standard CAPM-based capital budgeting criterion implies a notion of value which does not comply with the principle of additivity. Framing effects arise in decisions so that different descriptions of the same problem lead to different choices. As a result, the CAPM-based NPV as a tool for valuing projects and making investment decisions is theoretically unsound, even if the CAPM assumptions are met.

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