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
Date Written: May 1, 2008
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: Suggested Citation