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Read the article “Do we need CAPM for capital budgeting?” Do you agree or disagree with
the authors' position? Why or why not? Discuss with your classmates the characterization
of Jagannathan and Meler’s assumptions. Are they valid?
Read the article “Do we need CAPM for capital budgeting?” Do you agree or disagree with the authors' position? Why or why not? Discuss with your classmates the characterization of Jagannathan and Meler’s assumptions. Are they valid?
Since the capital budgeting plays an important role in business corporations, and the cost of capital is computed to make decisions regarding the projects which can maximize the firms value options available and CAPM is the predominate method to estimate the cost of capital, which is the rate investors need to undertake the investment after discounted the future cash flows. I agree with the statement that CAPM is needed for capital budgeting. The cost of capital is equivalent to risk premium plus a risk free rate and beta is used to measure the risk in the project.
Though, CAPM has been challenged in recent academic debates and literature and there have been some disagreements evident regarding risk premium which is the key input to the value of CAPM. There has been no consensus regarding that what is the reasonable value of the market risk premium. It is believed that widely used average market risk premium can overstate the realistic market risk premium by factor of two, the most. Therefore, authors of this paper are convinced that if the risk premium is not a true representative of the risk than why the managers of the corporate do not complain regarding this unrepresentative figure.
But Jagannathan and Meler’s in this paper have explained the true nature of this figure based on an assumption that organizational and managerial capital is rationed by the firms. So, the management does not take into count every project which can be accounted as an option. Rather they wait for the better investment opportunity to come their way with positive NPV and this also takes into account value of the options to wait. So author is arguing here that basically due to hurdle premium which is the difference between the project’s cost of capital and hurdle rate, firms find it very difficult to come up with the talented managers who can identify the opportunities which are true and realistic and do not overstate the premium risk.
To conclude, therefore, it can be argued that according to the assumptions made in this paper, that errors in the CAPM are unlikely to be critical for the companies according to other researchers too and present study also acknowledges the fact. So, Jagannathan and Meler’s argue that rather than many other factors also affect the discount factor figure and the magnitude of this figure has no impact on the final decision making regarding selection of the project. Therefore, I agree with the authors’ explanation here that further research us needed to understand the real position because hypothesis conducted so far have argued that discount rate is higher than the cost of capital.
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