CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence
51 Pages Posted: 18 Mar 2010
Date Written: March 15, 2010
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: Suggested Citation