Accounting‐based Risk Management and the Capital Asset Pricing Model: An Empirical Comparison

Abstract

Accounting‐based risk management (ABRM) is a theoretically consistent and practical tool for calculating the cost of capital from underlying financial ratios. In this paper, a sample of ABRM‐generated discount factors is used to generate risk‐adjusted returns, which are compared to CAPM equivalent discount factors. In view of the debates about CAPM's validity, alternative models, the nature and scale of the equity risk premium, and the importance of discount rates in capital budgeting and asset valuation, ABRM's characteristics and resulting discount rates offer a potentially useful alternative. Results suggest that although average discount rates are comparable, their cross‐sectional distributions are dissimilar, so that investors in an average risky firm are overcompensated for systematic risk when using CAPM discount rates, because CAPM discount factors overestimate risk arising from fixed costs in most firms.