CAPM for estimating the cost of equity capital: Interpreting the empirical evidence

Zhi Da, Re Jin Guo, Ravi Jagannathan*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

68 Scopus citations

Abstract

We argue that the empirical evidence against the capital asset pricing model (CAPM) based on stock returns does not invalidate its use for estimating the cost of capital for projects in making capital budgeting decisions. Because stocks are backed not only by projects in place, but also by the options to modify current projects and undertake new ones, the expected returns on stocks need not satisfy the CAPM even when expected returns of projects do. We provide empirical support for our arguments by developing a method for estimating firms' project CAPM betas and project returns. Our findings justify the continued use of the CAPM by firms in spite of the mounting evidence against it based on the cross section of stock returns.

Original languageEnglish (US)
Pages (from-to)204-220
Number of pages17
JournalJournal of Financial Economics
Volume103
Issue number1
DOIs
StatePublished - Jan 1 2012

Keywords

  • Asset pricing anomalies
  • Beta
  • Capital budgeting
  • Cost of capital

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management

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