CAPM for Estimating the Cost of Equity Capital:  Interpreting the Empirical Evidence

Da, Zhi; Guo, Re-Jin; Jagannathan, Ravi

CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence

NBER Working Paper No. w14889

61 Pages Posted: 20 Apr 2009 Last revised: 8 Sep 2010

See all articles by Zhi Da

Zhi Da

University of Notre Dame - Mendoza College of Business

Re-Jin Guo

University of Illinois at Chicago - Department of Finance

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad

There are 2 versions of this paper

Date Written: April 2009

Abstract

We argue that the empirical evidence against the Capital Asset Pricing Model (CAPM) based on stock returns does not invalidate its use for estimating the cost of capital for projects in making capital budgeting decisions. Since stocks are backed not only by projects in place, but also the options to modify current projects and undertake new ones, the expected returns on stocks need not satisfy the CAPM even when expected returns of projects do. We provide empirical support for our arguments by developing a method for estimating firms' project CAPM-betas and project returns. Our findings justify the continued use of the CAPM by firms in spite of the mounting evidence against it based on the cross-section of stock returns.

Suggested Citation: Suggested Citation

Da, Zhi and Guo, Re-Jin J. and Jagannathan, Ravi, CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence (April 2009). NBER Working Paper No. w14889. Available at SSRN: https://ssrn.com/abstract=1391836