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

See all articles by Carlo Alberto Magni

Carlo Alberto Magni

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering)

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

Magni, Carlo Alberto, Theoretical Flaws in the Use of the CAPM For Investment Decisions (December 2005). University of Modena and Reggio Emilia, December 2005, Available at SSRN: https://ssrn.com/abstract=1075404 or http://dx.doi.org/10.2139/ssrn.1075404

Carlo Alberto Magni (Contact Author)

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering) ( email )

Italy

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