Economic Profit, NPV, and CAPM: Biases and Violations of Modigliani and Miller's Proposition I

The ICFAI Journal of Applied Finance, Vol. 14, No. 10, pp. 59-72, October 2008

15 Pages Posted: 17 Dec 2007 Last revised: 14 Jul 2009

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)

Abstract

For one-period projects under certainty, the notion of Net Present Value (NPV) formally translates the notion of economic profit, where the discount rate is the cost of capital. Under uncertainty, the cost of capital 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 for risky one-period projects are not equivalent: NPV-minded agents are open to framing effects and to arbitrage losses, which imply violations of Modigliani and Miller's Proposition I. The notion of disequilibrium (present) value, deductively derived from the CAPM by several authors and widely used in applied corporate finance, should therefore be dismissed.

Keywords: Capital Asset Pricing Model, Net Present Value, economic profit, disequilibrium, framing effects, arbitrage, Modigliani and Miller's Proposition I

JEL Classification: G11, G12, G30, G31, G32

Suggested Citation

Magni, Carlo Alberto, Economic Profit, NPV, and CAPM: Biases and Violations of Modigliani and Miller's Proposition I. The ICFAI Journal of Applied Finance, Vol. 14, No. 10, pp. 59-72, October 2008 , Available at SSRN: https://ssrn.com/abstract=1075462

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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