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THEORETICAL FLAWS IN THE USE OF THE CAPM FOR INVESTMENT DECISIONS

Magni, Carlo Alberto (2005): THEORETICAL FLAWS IN THE USE OF THE CAPM FOR INVESTMENT DECISIONS.

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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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