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CAPITAL BUDGETING AND THE CAPITAL ASSET PRICING MODEL: GOOD NEWS AND BAD NEWS
Author(s) -
Myers Stewart C.,
Turnbull Stuart M.
Publication year - 1977
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1977.tb03272.x
THIS PAPER DERIVES and presents expressions for the market value of a long-lived capital investment project, assuming that the capital asset pricing model (CAPM) holds in each period. We use these expressions to examine the determinants of beta and to evaluate traditional capital budgeting procedures based on the discounted cash flow formula and the opportunity cost of capital. The good news is that it is possible to value capital investments using relatively simple formulas derived from the CAPM. Also, the traditional procedures give close-to-correct answers, provided that the right asset beta is used to calculate the discount rate. The bad news is that the right asset beta depends on project life, the growth trend of expected cash flows, and other variables which are not usually considered important in assessing business risk. Moreover, for growth firms the right discount rate cannot be inferred from the observed systematic risk of the firm's stock, even if the firm invests only in projects of a single risk class. The reason is that growth opportunities affect observed systematic risk.