Theoretical Flaws in the Use of the CAPM For Investment Decisions
University of Modena and Reggio Emilia, December 2005
20 Pages Posted: 17 Dec 2007
Date Written: December 2005
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.
Keywords: Capital budgeting, CAPM, investment decisions, nonadditivity, framing effects
JEL Classification: G12, G30, G31
Suggested Citation: Suggested Citation