Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I

Magni, Carlo Alberto (2005): Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I.

Abstract

The notion of Net Present Value (NPV) is thought to formally translate the notion of economic profit, where the discount rate is the cost of capital. The latter is the expected rate of return of an equivalent-risk alternative that the investor might undertake and is often found by making recourse to the Capital Asset Pricing Model. This paper shows that the notions of disequilibrium NPV and economic profit are not equivalent if the standard NPV+CAPM is employed: NPV-minded agents are open to framing effects and to arbitrage losses, which imply violations of Modigliani and Miller's Proposition I. The standard notion of disequilibrium (present) value, deductively derived from the CAPM by several authors, should therefore be dismissed.

• Item Type: MPRA Paper
• Language: English
• Keywords: Capital Asset Pricing Model, net present value, economic profit, disequilibrium, framing effects, arbitrage, Modigliani and Miller's Proposition I
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; G - Financial Economics > G1 - General Financial Markets > G10 - General; G - Financial Economics > G3 - Corporate Finance and Governance > G30 - General

References

Abel, A.B. (1990). Consumption and Investment. In B. M. Friedman and F. H. Hahn, Eds., Handbook of Monetary Economics. Amsterdam: North-Holland. Biddle, G.C., Bowen, R. M., & Wallace, J. S. (1999). Evidence on EVA. Journal of Applied Corporate Finance, 12, 69-79. Brackenborough, S., McLean, T. and Oldroyd, D. (2001). The emergence of discounted cash flow analysis in the Tyneside coal industry c.1700-1820. British Accounting Review, 33, 137-155. Begg, D., Fischer, S., and Dornbusch, R. (1984). Economics. Mc-Graw Hill, British Edition. Buchanan, J. (1969). Cost and Choice. An Inquiry in Economic Theory. Chicago: Markham. Republished as Midway reprint, Chicago: University of Chicago Press, 1977. Dybvig, P.H. and Ingersoll, J.E. (1982). Mean-variance theory in complete markets. Journal of Business, 55 (2), 233-250. Dixit, A. and Pindyck, R. (1994). Investment under Uncertainty. Princeton NJ: Princeton University Press. Edwards, E. and Bell, P. (1961). The Theory and Measurement of Business Income. Berkeley: University of California Press. Edwards, J. R. and Warman, A. (1981). Discounted cash flow and business valuation in a nine-teenth century merger: A note. The Accounting Historians Journal, 8 (2), 37-50. Fernandez, P. (2002). Valuation Methods and Shareholders Value Creation. San Diego: Academic Press. Fisher, I. (1930). The Theory of Interest. New York: Macmillan; (reprinted) Clifton, NJ: Augustum M. Kelley Publishers, 1974. Kahneman, D. and Tversky, A. (1984). Choices, values and frames. American Psychologist, 39, 341-350. Kay, J. (1976). Accountants, Too, Could Be Happy in a Golden Age: The Accountant's Rate of Profit and the Internal Rate of Return. Oxford Economic Papers, 28, 447-460. Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets, Review of Economics and Statistics, 47, 13-37. 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. (2003). Decomposition of Net Final Values: Systemic Value Added and Residual Income. Bulletin of Economic Research 55 (2), 149-176. Magni, C.A. (2004). Modelling excess profit. Economic Modelling, 21, 595-617. Magni, C.A. (2005). On Decomposing Net Final Values: EVA, SVA and Shadow Project. Theory and Decision, 59/1, 51-95. Magni, C.A. (2007a). Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM? forthcoming in European Journal of Operational Research, Available at <http://ssrn.com/abstract=1025998>. Magni, C.A. (2007b). CAPM and capital budgeting: present versus future, equilibrium versus disequilibrium, decision versus valuation. Available at <http://ssrn.com/abstract=1024716>. Marshall, A. (1890). Principles of Economics. London: MacMillan. Miller, P. and Napier, C. (1993). Genealogies of calculation. Accounting, Organizations and Research, 18 (7/8), 631-647. 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. Mossin, J. (1968). Equilibrium in a Capital Asset Market, Econometrica, 34 (4) 768-783. 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. Parker, R.H. (1968). Discounted cash flow in historical perspective. Journal of Accounting Research, 6 (1), 58-71. Peasnell, K. (1981). On Capital Budgeting and Income Measurement. Abacus, 17, 52-67. Preinrich, G. (1936). The Law of Goodwill. The Accounting Review, 11 (4), 317{329, December. Preinrich, G. (1938). Annual Survey of Economic Theory: The Theory of Depreciation. Econometrica, 6 (1), 219-241, January. Rao, R. (1992). Financial Management, MacMillan. Rubinstein, M.E. (1973). A mean-variance synthesis of corporate financial theory. Journal of Finance, 28, 167-182. Sharpe, W. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19, 425-442. Soman (2004). Framing, loss aversion, and mental accounting. In D. J. Koehler and N. Harvey, Eds., Blackwell Handbook of Judgment and Decision Making, pp. 379-398. Oxford, UK: Blackwell. Thaler, R.H. (1985) Mental accounting and consumer choice. Marketing Science, 4 (3), 199-214 Thaler, R.H. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12, 183-206. Tversky, A. and Kahneman, D. (1981) The framing of decisions and the psychology of choice. Science, 211, 453-458.