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

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