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

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

Ravi Jagannathan

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

Multiple version iconThere 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

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

Zhi Da

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

Re-Jin J. Guo

University of Illinois at Chicago - Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States
312-413-3718 (Phone)

Ravi Jagannathan (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
429 Andersen Hall
Evanston, IL 60208
United States
847-491-8338 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

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