CAPM ana Capital Budgeting Essay Example | Topics and Well Written Essays - 750 words

CAPM ana Capital Budgeting - canvass ExampleThe estimation of the personify of upper-case letter in turn is based upon the CAPM. However, not only does young discourses in academic literature challenge the validity of the CAPM model, there is lack of consensus regarding the adequate measure of the trade risk premium, a central input required for computing the cost of jacket crown apply the CAPM. However, in spite of these short comings, the CAPM has survived as the predominant quantitative model in its class for over 40 years since its inception. It is precisely this paradox the paper in concern addresses. In particular, Jagannathan and Meler (2002) offer an explanation to the pursuit question in spite of the various short comings of the CAPM model in computing the cost of capital, why do majority of managers report using the model to score critical decisions? The answer they offer is that in the real world, computing the exact cost of capital may not be crucial for optimal decisions. Hence, although the CAPM may not provide the exact value of cost of capital, but it still the Great Compromiser helpful for managers. Assuming rationed organizational and managerial capital which implies that not all projects with positive NPVs can be invested in, the paper shows that utilizing a hurdle rate greater than the cost of capital and the typical NPV computations, the value of postponement for an option can be accounted for. Therefore, the exact value of cost of capital no longer remains an imperative for optimal decisions. The idea that discounting values are set much higher than the cost of capital has significant support in financial literature. Stein (2001) for instance shows that aspects like agency costs arising come in of asymmetric informational situations among share owners and managers leads to setting of discount rates that are much higher than the actual cost of capital. Empirical literature excessively lends further support to the claim by est ablishing the existence of a round number of hurdle rates that are set higher than the cost of capital (Poterba and Summers, 1995). Truong, Partington and Peat (2008) have also established that there are a number of hurdle rates used in the capital budgeting procedure in Australia. The critiques of using CAPM in capital budgeting fundamentally stem from two particular vexedies. First, the clipping horizon of the basic model is limited to a single period. But in reality, investment estimations of firms typically involve decision making over six-fold periods. Thus, this raises the question of applicability of the CAPM in investment appraisal in the real world. Secondly, computing discount rates specific to particular projects can prove difficult owing to for instance, difficulties arising in identification of appropriate proxy betas as proxy companies usually undertake multiple activities simultaneously. Disentangling the beta specific to a project may prove near impossible becau se these require accredited information that may be extremely difficult to obtain. (Head, 2008) Additionally, it has been shown that although the NPV criterion can be utilized to make accept/reject decisions, these are valid and optimal only if the discount rate is not computed using the CAPM (Magni, 2009). In light of the discussion above what emerges essentially is that the CAPM generates estimates of cost of capital