Ranking Errors in CAPM Capital Budgeting Applications Author(s): Richard J. Rendleman, Jr.

Reviewed work(s): Source: Financial Management, Vol. 7, No. 4 (Winter, 1978), pp. 40-44 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665084 . Accessed: 08/02/2013 07:24
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Ranking

Errors

in

CAPM

Capital

Budgeting

Applications

Richard J. Rendleman, Jr.

J. Rendleman, Richard Jr., is AssistantProfessor School of Management of Financeat the Graduate at NorthwesternUniversity.

* The Sharpe-Lintner-Mossin CapitalAsset Pricing Model (CAPM) provides a frameworkfor valuing certain types of financialassets in a perfect and efficientcapitalmarket.Rubinstein [6], Weston[8], and othershave appliedthe modelto the firm'scapitalexthe equilibrium valueof pansiondecisionto determine the financialclaims that are used to finance a particular asset under consideration.If this value is greaterthanthe asset'spurchase price,thenthe wealth of the shouldinfirm's current shareholders position in the two values.On the other creaseby the difference hand, if the capitalizedvalue of the project'scash flows is less than its cost, the projectshould be remeans jected, andthe firmshouldconsideralternative
of expansion.

The use of the CAPM for capital budgetinghas [5] recentlycome underattackby MyersandTurnbull and Fama [1]. These authors have shown that the CAPM cannot always be effectivelyemployedas a the properdiscountratefor a methodfor determining project. For example, Fama shows that in order properlyto employ the CAPM to determinea cono 1978 Financial Management Association
40

stant requiredrate of return,there can be no uncerthe futurerisklessinterestrate,the taintysurrounding market price of risk, or the systematicrelationship between proportionalchanges in the project's expected cash flows and the market return.Expected cash flows are the only parameter whosevaluecan be uncertain through time. Moreover, expected cash flows must evolve throughtime as a martingale.In otherwords,the expectedcash flow at anytime t must be the best estimatefor the cash flow at t + 1. Myers and Turnbulldemonstratethat, if a project's cash flows do not evolve as a martingale,the project'sbeta will dependupon the life of the project and the growthrate of the cash flows. Moreover,the observed systematicrisk of the firmshouldreflectthe risk of its tangibleassetsas well as its moreuncertain When all these factors future growth opportunities. are consideredtogether,it is unlikelythat observed of the "true"systematic betas will be representative betweenthe firm'scash flows and overall relationship economicactivity. This paperassumesthat the conditionsspelledout

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ERRORS RENDLEMAN/RANKING

41

by Myersand Turnbulland Fama for properlyusing the CAPM for determining a project's rateof required returnare met. Evenundertheseconditions, potential errorscan arisewhenrankingprojectson the basis of their expected excess returns if market-determined measures of systematic risk rather than measures reflectingprojectcost are employedto determinethe requiredrates of return.Thus, anotherchallengeis presentedto the practicalusefulnessof the model.

Project Selection
Rubinstein has shownthat the equilibrium valueof a project,Vj, will be greaterthan its cost, Cj, if the followinginequalityholds:
Xj Xcj

>

+ RF+ XCOV (C ,m),

j

(1)

whereXj is a randomvariablewith meanXj denoting the end-of-period valueof the project,Am is the return on the marketportfolio,RFis the risklessinterestrate, Xis the "marketpriceof risk"whichis assumedto be constantacrossall financialassets, and COV (., .) is the covariance Thiscriterion indicatesthat a operator. project should be acceptedif its expected returnis risk that higherthanthat of otherassetsof equivalent sell for equilibrium prices.Inequality (1) can be alternativelystated in a more familiarform as
ci

> 1 +RF+/ (E[r

]-RF)

wheref is the beta of the asset'sreturnswith respect to the returnon the marketportfolioand E (.) is the expectationoperator.Since
COV ( ,j

covariance and the latter as the equilibrium covariance. The problemaddressed in this analysisarisesfrom the difference between these covariances.The discovariancemust be estimatedon an ex equilibrium ante basis, which is quite difficultto do in practice, becauseit involvesthe estimationof the covariance betweenthe project'send-of-period cash flow and the marketreturn- a numberwhich few can grasp intuitively.Even if the covarianceterm is transformed into the morefamiliarbeta,the samecalculation must still be made. To avoid having to make this type of ex ante calculation,one might look to the securitiesmarket and measure covariancesor betas from historical return data of firms with economic characteristics similar to those of the projectunderconsideration. The problemwith this approachis that measuresof systematic risk so obtained are likely to be better proxies for the equilibriummeasure(assumingthat the market is in equilibrium)than for its disequilibrium counterpart. no errorwill resultif one interchanges Fortunately, the covariancesin (1) and as a basis for the acceptrate rejectdecisionuses a market-determined required of returnof assets selling for equilibrium priceswith similar economic characteristicsas the project. A projectwill have a positivenet presentvalueif its exis greaterthanits required rateof return pectedreturn covarianceas in (2), below.* using the equilibrium

ci

>

+ RF + XCOV (

Vi,

m)

(2)

1 V=

j VAR (Am)

m)

where VAR (Am) is the vari-

However,if projectsare rankedon the basis of excovariance pectedexcess returns,and the equilibrium is used, potentialrankingerrorscan result.

ance of the marketreturn,then

E( ) - R F . Thus, all references to the sysVAR (Rm)

Project Rankings
In the absenceof capitalrationing, a firmshouldbe unconcerned with projectrankingsunlessthe projects underconsideration are mutuallyexclusive.The firm should simply invest in those projects that have a positivenet presentvalue.
*If a project does not have a positive net present value, then Cj > Vj and x x < ( + RF) + XCOV(

tematic risk of a project, measuredin terms of its can be alternatively viewedas a reference covariance, to the project'sbeta. termin (1) does not repreActually,the covariance sent the equilibriumsystematic risk of the project. Assuming that the project's equilibriumvalue is termwilldecrease greaterthanits cost, the covariance
from COV (

5:
Cj

value.We will projectis capitalizedat its equilibrium refer to the former term as the disequilibrium

Cj

j,

Am)

to

COV(Xj ,
Vj

fm) when the

Cj

, Am).

Since Vj < C, we can substitute Vj for Cj in the covariance term and still maintain the inequality. As a result, criterion (2) cannot give rise to an incorrect accept-reject signal for a project.

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42

FINANCIALMANAGEMENT/WINTER 1978

Whether or not we believe that capital rationing can exist in an efficient capital market, it appears that many firms operate in a capital rationing environment. For example, in a recent survey appearing in Financial Management, Gitman and Forrester found that approximately 50% of the firms surveyed operate under capital rationing and "attempt to allocate a fixed budget on a competitive basis" [2, p. 69]. Even in the absence of capital rationing, it would appear that firms ought to be concerned with project rankings, because projects with the highest net present values are likely to be the least sensitive to exact specifications of expected cash flows and costs of capital. Moreover, even if these estimates are made as precisely as possible for a given economic environment, the most profitable projects are least likely to be rejected, given a change in the economic setting. Therefore, it is important to understandthe conditions under which a project selection criterion ranks projects correctly. A formal analysis of the ranking problem is presented in the appendix. The problem does not occur when projects are evaluated using net present values calculated at rates based on equilibrium or market-determined measures of systematic risk. It does not occur if the excess of internal return over required return is used in ranking projects of the same scale when required return reflects the systematic risk associated with project purchase price rather than the market value of the project in place. Ranking becomes a problem when required return is calculated conventionally by using an equilibrium or market-determined measure of systematic risk and comparing this figure to internal return.

Project i has the higher net present value and would be the higher ranking of the two projects on this basis and the better mutually exclusive choice for a wealthmaximizing firm. However, if the firm were to rank these two projects on the basis of excess of internal return over equilibrium or market-determined return, then the firm would be misled: Projecti Covariance of Equilibrium Return withMarketReturn, ReturnBasedon Required or MarketEquilibrium Determined Risk, Systematic Rf + X[COV(,f, m)/V] Internal Return, (X/C) - 1 Excessof Internal Over Return Required
COV (X, tm)/V .1405

Project j

.4206

.1905 .4204

.4706 .7045

.2299

.2339

Ranking on this basis favors Project j. If the ranking were used to choose between these two projects then, clearly, wealth would not be maximized. The problem can be solved with an excess return ranking system, but the solution requires that the acquisition cost of the project be recognized in calculating required return: Projecti Covariance of ActualProject Return withMarketReturn, ReturnBasedon Required Cost Determined Acquisition Risk, Systematic Internal Return, (X/C) - 1 Excessof Internal over Return Required
Rf +X [COV (,, lm)/C] .2176 .4204 .2028 .5375 .7045 COV (Xt, m)/C

Project j

.1676

.4875

Illustration
An illustration, involving two one-year projects of the same scale, i and j, should help to make the issues clear. In the illustration, the risk-free rate, RF is .05, and the "market price of risk," X, is 1. The information on projects i and j is as follows: Projecti Endof Period Expected Value,X Covariance of Endof PeriodValuewithMarket COV(X, lm) Return, Equilibrium ProjectValue,
V = [XX COV (fX, m)]/

.1670

Project j
$150

$125

$ 14.75 $105 $ 88 17

$ 42.90 $102 $ 88
14

Costof Project,C Net PresentValue,NPV

(1 + R,)

With required return based on project acquisition cost, the ranking is correct. This problem exists for any capital asset pricing model that provides risk-adjusted project screening rates. The implication for the Sharpe-Lintner-Mossin Model is that one must estimate the risk of a project as a function of the riskiness of its own cash flows and not that of another similar asset selling for an equilibrium price. Therefore, it is inappropriate for a firm to use its own beta when computing the expected excess return of a project with risk characteristics identical to the firm itself. In the same way, it is inappropriate to use the beta of any firm involved in an activity analogous to a project in computing excess

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ERRORS RENDLEMAN/RANKING

43

return. This presents a problem for the practical applicability of the model because the required acquisition cost-based estimates of systematic risk are difficult to make on a subjective basis. On the other hand, if the concern in capital budgeting is whether or not a project should be accepted or rejected, a marketdetermined measure of systematic risk can be employed to determine a project's required rate of return.

Finally, if 1 + RF is subtracted from both sides of (A2), the inequality can be expressed in terms of expected excess returns: X ( + RF] + +XC)> XCOV[ C - ([1
c c

, alm])>
(A-3)

xj

-( ([1+ RF] - XCOV [--,-IM).

Thus, project i has a higher net present value than j if

References
1. Eugene F. Fama, "Risk Adjusted Discount Rates and

Capital Budgeting Under Uncertainty,"Journal oj

Financial Economics (August 1977), pp. 1-24.

2. LawrenceJ. Gitman and John R. Forrester,Jr., "A Used by Major Techniques Surveyof CapitalBudgeting
U.S. Firms," Financial Management (Fall 1977), pp. 66-71.

its expectedexcess returnis higherthan that of j. terms of (A-3) are based Note that the covariance returns of the projectscalculated the upon anticipated to theirpurchase with reference prices,whichmay be differentfromtheirequilibrium prices.If a difference

3. John Lintner,"The Valuationof Risk Assets in Stock Portfoliosand CapitalBudgets,"Reviewof Economics and Statistics (February1965),pp. 13-37. in a CapitalAsset Market," 4. Jan Mossin, "Equilibrium Econometrica (October1966),pp. 768-83. 5. Stewart C. Myers and Stuart W. Turnbull,"Capital Budgetingand the CapitalAsset PricingModel: Good News and Bad News,"Journalof Finance(May 1977), pp. 321-32. "A Mean VarianceSynthesisof Cor6. Mark Rubinstein, porate FinancialTheory,"Journalof Finance (March 1973),pp. 167-81. 7. WilliamF. Sharpe,"CapitalAsset Prices:A Theoryof of Risk,"Journal MarketEquilibrium underConditions of Finance(September1966),pp. 425-42. 8. J. Fred Weston, "Investment Decisions Using the Capital Asset Pricing Model," FinancialManagement (Spring 1973),pp. 25-33. Appendix.

exists, the covariance terms will not be the same as those obtained by measuring the systematic risk of similar assets that sell for equilibrium prices. If one ranks projects on the basis of their expected excess returns, it is possible that the rankings will be

incorrect if market-determined required rates of the potentialerror, returnare employed.To illustrate considera situationin which both i and j have the
same cost, C, but project i has a higher equilibrium value than project j. In addition, assume that both projects have a positive net present value, in which case C < Vj < Vi. If market-determined equilibrium expected returns are used in the computations, an error will result if

Xj _ Xj
C Vj

Xi
C

Xi
Vi,

(A-4)

(A-4) states that project Inequality j has the higher expectedexcess return.However,we have assumed that i has the highernet presentvalue. Therefore,a potentialrankingerrorcan occu0 if it is possiblefor
both conditions to hold simultaneously. Under what

Considertwo projects,i andj, both of whichcan be for the sameprice,C. By employing the dispurchased counted certaintyequivalentversion of the CAPM, projecti has a highernet presentvalue thanj, if
Xi COV (Xi, m) > Xj

will this be possible? circumstances higherexpectedexcess returnif < (j - Xi)

By solving (A-4) in terms of C, project j will have a

1 + RF

COV (j, Afm)

1 + RF

Xi)
v1

(A-5)

J (A-l) provided that the quantity (-

By multiplying (A-l) by 1 + RF and dividing by the

cost of the projects,we findthat projecti has a higher net presentvalue if

-i- X COV (

-X) is positive. OthVi erwise, the inequality will be reversed. If Vj < Vi, we can only be assured that this quantity is positive if Xj > Xi. In addition, the fact that Vj < Vi implies that C
-j

t ,m)>

-X COV ( -

,m).

stituting Vj for Vi in (A-5) and cancelling (Xj - Xi). (A-2)

< Vj < Vi as long as Xj > Xi. Thiscan be seenby sub-

The inequalitythen becomesC < Vj.

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44

1978 FINANCIALMANAGEMENT/WINTER

If (V'vj

Vi

X')is negative,the inequalitywill be re-

cause an error. The final factor to be considered is the relationshipbetween the covariance terms,
COV (Xj, ftm) and COV (Ri, km), with Xj > Xi. Since

versed.Since it has been assumedthat projecti has a value than j, Xi must be greater higherequilibrium than Xj to ensure that this quantity is negative. the factthatVj < Vi However,undertheseconditions, > > neither or that that C Vi Vj, projecthas a implies it is value. net Therefore, not possible positive present for rankingerrorsto occur for projectswith positive net presentvaluesif their costs are the same and the projectwiththe higherexpectedexcessreturn(project payoff. j in this analysis)has the lowerend-of-period Although it is possible that a rankingerror can occurif the projectwiththe higherexpectedexcessreturn has the higher expected end-of-periodpayoff
(i.e., Xj > Xi), this is not a sufficient condition to

the equilibriumvalue of any project is given by X - COV (X, Rm) , the only way that Vj can be less 1 + RF thanVi, andXj be greaterthanXi, is if COV (&j,tm)
> COV (Xi, Atm).

To summarize,no rankingerror can occur if the is usedto calculateexpected covariance disequilibrium covarianceis used, excess returns.If the equilibrium no errorcan occurif eitherXj < Xi or COV (Xj, tm) < COV(Xi, tm), where j is the projectwiththe higher are excessreturn.However,if bothof theseconditions will be satisfiedalongwith(A-5), thenthe two projects rankedincorrectly.

FINANCIAL MANAGEMENT ASSOCIATION NINTH ANNUAL MEETING CALL FOR 1979 PROGRAM
The Financial Management Association brings together practicing financial managers from and membersof the organizations, industry,financialinstitutions,and nonprofitand governmental The ninth annual investment in financial and academiccommunitywith interests decision-making. will stressthe in program,October11-13, 1979,at the SheratonBostonHotel Boston,Massachusetts, investment betweentheoryand practicein financialand Proposalsto management. interrelationships for the 1979 are solicited abstracts in the formof completed papersor two-page(maximum) participate no later be received All papersand abstractsshould are encouraged. meeting.Studentcontributions to the Vice-Presidentare invitedto respond andnon-members thanFebruary 28, 1979.Bothmembers Program,GeorgeH. Hempel,Cox School of Business,SouthernMethodistUniversity,Dallas,Texas
75275, Telephone (214) 692-2590. 1979 Annual Meetings Dates: Place: October 11-13, 1979 Sheraton Boston Hotel Boston, Massachusetts

GeorgeH. Hempel Participation: Professor Program EdwinL. Cox Schoolof Business MethodistUniversity Southern Dallas,Texas75275 Tel:(214)692-2590 FrankCampanella MeetingArrangements: Professor Vice-President Executive BostonCollege 02167 Chestnut Hill, Massachusetts Tel:(617)969-0100 DonaldJ. Puglisi Information Professor Placement & Economics Collegeof Business of Delaware University Newark,Delaware19711 Tel:(302)738-2556

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