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

51 Pages Posted: 18 Mar 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: March 15, 2010

Abstract

We argue that the CAPM may be a reasonable model for estimating the cost of capital for projects in spite of increasing empirical evidence in the literature against the CAPM based on stock returns. As McDonald and Siegel (1985) and Berk, Green and Naik (1999) point out, stocks are backed by projects in place as well as options to modify existing projects and undertake new projects. In that case, the expected return on stocks need not satisfy the CAPM even when project expected returns do. We propose a method for estimating firms' project betas and project returns and find that there is a linear relation between the two. Our findings support the use of the CAPM along with real option valuation models in project evaluation.

Keywords: Cost of Capital, CAPM, Capital Asset Pricing Model, Capital Budgeting

JEL Classification: G0, G12, G30, G31

Suggested Citation

Da, Zhi and Guo, Re-Jin J. and Jagannathan, Ravi, CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence (March 15, 2010). UIC College of Business Administration Research Paper No. 10-06. Available at SSRN: https://ssrn.com/abstract=1571299 or http://dx.doi.org/10.2139/ssrn.1571299

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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