CAPM-based capital budgeting and nonadditivity

Magni, Carlo Alberto (2006): CAPM-based capital budgeting and nonadditivity.

Abstract

This paper deals with the CAPM-derived capital budgeting criterion, and in particular with Rubinstein’s (1973) criterion, according to which a project is profitable if the project rate of return is greater than the risk-adjusted cost of capital, where the latter depends on the project’s disequilibrium systematic risk. It is shown that the disequilibrium net present value implied by this criterion, widely used in corporate finance, is nonadditive. Four proofs are provided: (i) a counterexample taken from Copeland and Weston (1988), (ii) a modus-tollens argument showing that this notion of NPV is incompatible with additivity, (iii) a formalization showing that this NPV does not fulfil the principle of description invariance (iv) an example showing that CAPM-minded evaluators may incur arbitrage losses.

• Item Type: MPRA Paper
• Language: English
• Keywords: NPV, disequilibrium, CAPM, capital budgeting, nonadditivity
• 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

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