CAPITAL BUDGETING – THE CAPITAL ASSET PRICING MODEL (CAPM) ISSUE

INTRODUCTION

An important function of a financial department is to ensure the input of the cost of capital. The most commonly used process by the financial departments globally is the CAPM, which is to understand the market risk premium. Literature dictates that calculation data should be based on the historical value of the US equity premium as the benchmark for the market risk premium (Jagannathan and Meier, 2002). There is a plethora of literature, both challenging and supporting the CAPM. In Jagannathan and Meier, (2002) research paper the authors claim that some academics are of the opinion that the true market risk premium could possibly be as low as half of the historical US equity premium in the past 20 years. This essay will attempt to provide a critical assessment of the CAPM in capital budgeting decisions

CAPM OVER THE YEARS

Until 1950s academic literature recommended to use of historical average returns of a company's equity, or a group of companies returns computable in the calculating of the cost of equity capital. The CAPM was developed by Sharpe in (1964) and in (1965) Lintner in his paper “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets an alternative” proposed a certain amendments to the theory and calculation. CAPM is a calculation that determines the cost of capital for a project and at the same time how cost can be predicted using data derived from a Beta of the said project and data relating to the market risk premium. Fama and French provided critique of then CAPM in 1992 in their paper “The Cross-Section of Expected Stock Returns”. Since this publication, academics and experts alike are of the opinion that CAPM is not a good model. This is mostly derived from Fama and French’s (1992) observation that the CAPM does not provide an accurate estimate of the cost of capital and is therefore detrimental to the capital budgeting process in toto. In addition, related difficulties include (and there is substantial literature that suggests) the market risk premium is also to be blamed. It is suggested that the risk premium is considerably smaller than initially envisaged (Jagannathan and Meier, 2002).  

Empirical support for the CAPM model especially the study of Black, Jensen, and Scholes (1972) “The Capital Asset Pricing Model: Some Empirical Tests” which supported CAPM in the calculating the cost of capital. Interestingly the study of Fama and Macbeth (1973) “Risk, Return and Equilibrium: Empirical Tests” was then empirically supportive of Sharpe (1964) and (1965) Lintner. Black et al. (1972), and Fama and Macbeth (1973) studies found a contingency in using the combined Beta of NYSE stocks during the period 1931 to 1965 in the predictive calculation of the CAPM. In addition, Fama and Macbeth (1973) went further in the examination to determine whether their characteristics of stock to understand its returns. The focus was given to the eccentric volatility of returns and the squared value of the return. The authors found strong evidence that the treatment of the Beta by using the data for the period 1926 to 1968 of the NYSE (Jagannathan and Meier, 2002).

It appears that there have been many challenges within academic circles as to the correctness or validity of the CAPM in practice. The study of Banz (1981) is of interest as an empirical position challenging the validity of CAPM. Banz (1981) revealed that equities of smaller firms have a higher earning potential than predicted by CAPM. Benz (1981) went further than Fama and Macbeth’s (1973) examination of the cross-sectional variations in calculating the average returns of firms listed on the NYSE between 1936 and 1975. This catalyst finding resulted in the academic community to respond that the CAPM should be regarded as an abstraction from reality, meaning that expecting the CAPM to grip is an unreasonable expectation. In my opinion, these two viewpoints are a world apart and problematic for any manger attempting to reasonably predict the cost of capital for budgeting decisions.

 Further, small firms are only representative of a small portion of the NYSE. And this is obviously of economic importance in validating the cost of capital. This finding makes Banz (1981) study not so important in discouraging practice to discontinue to use CAPM. This brings me back to the study of Fama and French (1992), which did indicate a significant challenge in the economic viability of CAPM. The authors approached the research question by using the same procedure as Fama and Macbeth (1973) did. This procedure made use of ten size classes and ten beta classes. The result was that there was no methodical relation between risk and return when measured by Beta. This regression analysis revealed that the size of the company and the book to market equity ratio perform better in ascertaining cross-sectional variances of the cost of capital (Jagannathan and Meier, 2002).

Fama and French (1992) were also criticized. Literature shows that the following evidence contradicts the authors interpretations or findings (Jagannathan and Meier, 2002):

1.   There is evidence of noise in the calculation of the estimated coefficients.

2.   The size factor as an effect on CAPM calculations can be attributed as a mere sample period effect. And last

3.   The data that was used (apart from the noise) also revealed to have elements of survivorship bias.  

 Strong support was found in the empirical study of Jagannathan and Wand (1996) who suggests that the static of CAPM can be more accurately applied by introducing growth rate of labour income as a representative of the return of human capital and allowing betas to progress over time.

CONCLUSION

The CAPM is widely used in practice and is well documented in empirical research and textbooks alike. Srithongrung, (2017) suggest that the response for this is that a healthy capital market, the cost of capital will systematically adjust to make provision in the equation of supply and demand for financial capital. However, human talent and organisational capital remain rationed, implying that the hurdle premium rate is high, inclusive of a risk premium (especially in emerging economies), and thus will the budgeting in the cost of capital for projects increase (Jagannathan and Meier, 2002).

 References

 Banz, R.W., 1981, “The Relationship Between Return and Market Value of Common Stocks,” Journal of Financial Economics 9, 3-18.

Fama, E.F., and K.R. French, 1992, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47, 427-465.

Fama, E.F. and J.D. Macbeth, 1973, “Risk, Return and Equilibrium: Empirical Tests,” Journal of Political Economy 81, 607-636.

Jagannathan, R. and Meier, I. (2002). Do We Need CAPM for Capital Budgeting?. Financial Management, 31(4), p.55.

Black, F., M.C. Jensen, and M. Scholes, 1972, “The Capital Asset Pricing Model: Some Empirical Tests,” in M. Jensen, Ed., Studies in the Theory of Capital Markets, New York, NY, Praeger, 79-121

Jagannathan, R., and Z. Wang, 1996, “The Conditional CAPM and the Cross-Section of Expected Returns,”

Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1), p.13. Journal of Finance 51, 3-53.

Sharpe, W.F., 1964, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” Journal of Finance 19, 425-442.

Srithongrung, A. (2017). Capital Budgeting and Management Practices: Smoothing Out Rough Spots in Government Outlays. Public Budgeting & Finance, 38(1), pp.47-71.