Firm Value and the mis-use of the CAPM for valuation and decision making

Magni, Carlo Alberto (2005): Firm Value and the mis-use of the CAPM for valuation and decision making. Forthcoming in: Applied Economics Research Bulletin (Peer-Reviewed Working Paper Series) (2009)

Abstract

The use of CAPM‐based disequilibrium betas and Net Present Value (NPV) for investment decisions and valuations is widespread in finance. Actually, its use is logically deducted from the CAPM assumptions. This paper deals with decisions about purchase of a firm and the related issue of firm valuation. In particular, it contrasts disequilibrium betas and NPVs with Modigliani and Miller’s Proposition I, and shows that disequilibrium betas and NPVs should not be used because they lead to irrational valuations and unreliable decisions; in particular, they lead decision makers to infringe Modigliani and Miller’s Proposition I. To prove the thesis, a counterexample is shown where two firms with same expected free cash flows are valued, one of which is levered, the other one is unlevered. A formal generalization is also provided. The results indicate that the use of disequilibrium NPV should be avoided, because valuations are incorrect and decisions are unsafe, leaving decision makers open to framing effects and arbitrage losses.

• Item Type: MPRA Paper
• Language: English
• Keywords: Firm value, Free Cash Flow, CAPM, Modigliani and Miller’s Proposition I, Net Present Value, disequilibrium, arbitrage, decision making.
• Subjects: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M2 - Business Economics > M21 - Business Economics

References

Bossaerts, P. and Ødegaard, B. A. (2001). Lectures on Corporate Finance. World Scientific

Brealey, R. and Myers, S. C. (2000). Principles of Corporate Finance. New York: McGraw-Hill, 6th edition.

Damodaran, A. (1999). Applied Corporate Finance: A User’s Manual. New York: Wiley.

Dybvig, P. H. and Ingersoll, J. E. (1982). Mean-variance theory in complete markets. Journal of Business, 55(2), 233–250.

Fernández, P. (2002). Valuation Methods and Shareholders Value Creation. San Diego: Academic Press.

Kahneman, D., Slovic, P. and Tversky, A. (1982). Judgment under uncertainty: Heuristics and biases. Cambridge, UK: Cambridge University Press.

Kahneman, D. and Tversky, A. (1984). Choices, values and frames. American Psychologist, 39, 341–350.

Magni, C.A. (2002). Investment Decisions in the Theory of Finance: Some Antinomies and Inconsistencies. European Journal of Operational Research, 137/1, 206–217.

Magni, C. A. (2007). Project valuation and investment decisions: CAPM versus arbitrage, Applied Financial Economics Letters, 3(1), 137–140, March.

Modigliani, F. and Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48, 261–297.

Nau, R. (1999). Arbitrage, incomplete models, and other people’s brains. In M. Machina and B. Munier, Eds., Beliefs, Interactions, and Preferences in Decision Making, Kluwer Academic Press. Nau, R. and McCardle K. (1991). Arbitrage, rationality, and equilibrium. Theory and Decision, 31, 199–240.

Qualls, W. J. and Puto, C. P. (1989). Organizational climate and decision framing: An integrated approach to analyzing industrial buying decisions. Journal of Marketing Research, 24, 179– 192.

Rao, R. (1992). Financial Management, MacMillan.

Roszkowski, M. J. and Snelbecker, G. E. (1990). Effects of “framing” on measures of risk tolerance: Financial planners are not immune. The Journal of Behavioral Economics, 19(3), 237–246.

Rubinstein, M. E. (1973). A mean-variance synthesis of corporate financial theory. Journal of Finance, 28, 167–182.

Tversky, A. and Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211, 453– 458.