CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence


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.

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Last time updated on 06/07/2012

This paper was published in Research Papers in Economics.

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