CAPM-Based Capital Budgeting and Nonadditivity

Journal of Property Investment and Finance, Vol. 26, No. 5, pp. 388-398, 2008

15 Pages Posted: 7 Jan 2008 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)

Date Written: May 1, 2008

Abstract

This paper deals with the CAPM-derived capital budgeting criterion, and in particular with Rubinstein's (1973) criterion, according to which a project is profitable if the project rate of return is greater than the risk-adjusted cost of capital, where the latter depends on the project's disequilibrium systematic risk. It is shown that the disequilibrium net present value implied by this criterion, widely used in corporate finance, is nonadditive. Four proofs are provided: (i) a counterexample taken from Copeland and Weston (1988), (ii) a modus-tollens argument showing that this notion of NPV is incompatible with additivity, (iii) a formalization showing that this NPV does not fulfil the principle of description invariance (iv) an example showing that CAPM-minded evaluators may incur arbitrage losses. The disequilibrium NPV should therefore be dismissed in investment decisions and valuations.

Keywords: Investment, decision, valuation, NPV, disequilibrium, CAPM, capital budgeting, nonadditivity, framing effects

JEL Classification: G11, G12, G30, G31, M21

Suggested Citation

Magni, Carlo Alberto, CAPM-Based Capital Budgeting and Nonadditivity (May 1, 2008). Journal of Property Investment and Finance, Vol. 26, No. 5, pp. 388-398, 2008. Available at SSRN: https://ssrn.com/abstract=1081193

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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