Do We Need CAPM for Capital Budgeting?

Abstract

A key input to the capital budgeting process is the cost of capital. Financial managers most often use the CAPM to estimate the cost of capitalfor which they need to know the market risk premium. Textbooks advocate using the historical value for the US 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 US 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 20 years, why has no one complained? We provide an answer to this puzzle. The classic rule for making capital budgeting decisions is to take projects with positive Net Present Value (NPV). Consider a project that generates an annual, real cash flow of $100,000 forever, starting one year from now. The initial investment is $1,600,000. To decide whether to invest in this project or not, we discount all future cash flows and subtract the initial investment to get the NPV. The decision rule is then simple: if the NPV is positive, take it; if the NPV is negative, leave it. The current textbooks used in all major MBA courses advise financial managers to calculate the cost of capital based on the Capital Asset Pricing Model (CAPM). The project's cost of capital is the rate investors require to undertake the investment, and we should discount all future cash flows at this rate. The cost of capital in the CAPM equals the riskfree rate plus a risk premium. The CAPM asserts that the only relevant risk measure for a project is its beta. The beta factor times the excess return of the market over the riskfree rate determines the risk premium of the investment. A key input for the CAPM is the excess return of the market over the riskfree rate, the market (equity) risk premium. The common practice has been to use the historical average return over a long period as a measure of what investors expect to earn. As a proxy for the market portfolio, a broad equity market index is applied. For the US the average market risk premium of the S&P 500 was 7.43% during the post-war period, whereas the real riskfree rate (six-month commercial paper) was 2.19%. Assuming that the project beta is 1.0 and the firm is 100% equity financed, the cost of capital is 2.19% + 1 x 7.43% = 9.62% and the NPV of our project is negative: 100,000/ 0.0962 - 1,600,000 = -$560,499. We would decide against investing. However, a new strand of literature starting with Blanchard (1993) takes a forward-looking perspective to determine the market risk premium. Instead of taking an average over a past