When Are Investment Projects in the Same Risk Class?

Accounting and Finance, Forthcoming

11 Pages Posted: 23 Jul 2015 Last revised: 29 Jul 2015

See all articles by David Johnstone

David Johnstone

University of Sydney Business School; Financial Research Network (FIRN)

Date Written: January 30, 2015

Abstract

If two investments have the same payoff covariance with the market but one has higher expected payoff, which asset according to the CAPM has most risk? One answer is that as far as risk goes the two assets are the same, because they have the same covariance with the market. The correct answer, pointed out nearly four decades ago by Eugene Fama, but long overlooked, is that investments have the same risk, the same returns beta and the same CAPM discount rate if and only if they have the same ratio of ex ante payoff covariance to payoff mean. This insight clarifies much of the conventional wisdom that surrounds capital budgeting and "risk adjusted" discount rates, while also displaying the mechanics by which information arrival affects the CAPM cost of capital.

Keywords: CAPM, cost of capital, cash flow beta

JEL Classification: G30, G31, G10, G12, D81

Suggested Citation

Johnstone, David, When Are Investment Projects in the Same Risk Class? (January 30, 2015). Accounting and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2634248

David Johnstone (Contact Author)

University of Sydney Business School ( email )

Instute of Transport and Logistics Studies (C37)
The University of Sydney
Sydney, NSW 2133
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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