Do We Need CAPM for Capital Budgeting?
46 Pages Posted: 17 Jan 2002 Last revised: 6 Jan 2003
Date Written: January 2002
A key input to the capital budgeting process is the cost of capital. Financial managers most often use the CAPM for estimating the cost of capital for which they need to know the market risk premium. Textbooks advocate using the historical value for the U.S. equity premium as the market risk premium. The CAPM as a model has been seriously challenged in the academic literature. In addition recent research indicates that the true market risk premium might have been as low as half the historical U.S. equity premium during the last two decades. If business finance courses have been teaching the use of the wrong model along with wrong inputs for twenty years, why has no one complained? We provide an answer to this puzzle.
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