Esteban Echeverry

Financial Tools: On the Drawbacks and Benefits of the CAPM and NPV

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a cognitive framework that explains the return that investors require from a financial asset for considering its inclusion into their their financial portfolios (berk, demarzo2020). It does that by establishing that only risk that derives from the market overall (i.e. systematic) should be rewarded, disregarding the one that comes from individual firms (i.e. idiosyncratic), as the latter could be eliminated through the practice of diversification (subrahmanyam, avanidhar2013). To do otherwise, would imply opening up a window for abitrage in which investors could acquire money at a risk-free rate and invest it in a portfolio of idiosyncratic-risky securities that would yield higher returns without any compromise. The CAPM maintains that in an efficient market such opportunities are implausible or at least ephemeral, as the increased demand for such attractive assets would increase their prices and diminish their returns until they match their level of risk, as stated by the Law of One Price (smith, tom_2013).

CAPM Equation
CAPM: Capital Asset Pricing Model Equation

These assumptions in which the CAPM relies, however, are subject of great debate. To begin, because the model implies that the expected returns of all financial assets move around the securities market line which starts from the risk-free rate and crosses the optimal market portfolio, it is sensible to ask ourselves how risk free is such risk-free rate of return (michael, schmidt_2018). For instance, it is true that the government of the United States has never defaulted on its debt obligations, but we must not forget that it is a political institution whose interests don't fully overlap with those of the market. What could happen if a newly elected president raises debt obligations to unsustainable levels in order to finance expensive social programs as part of his political programme? The US democracy might be exemplar to the world, and it has strong institutions that are capable of filtering out deleterious agents. But, in nowadays hyperconnected world, the likelihood of paradigm shifts happening overnight should not be underestimated. Could all those depending on the CAPM adapt on time if the risk-free rate, which is the most elemental of its components, is compromised?

Another supposition the CAPM model makes, is that to arrive to an estimation of the expected return of any security, it is only necessary to evaluate its historical correlation with the market, captured as the asset's beta. This departs from assuming that past and future events affecting a financial asset originate from the same probability distribution, which is logical and the best we can do upon our inability to foresee what is going to come. But at doing so we are also presuming that there is inherent predictability in the behaviour of all securities, which is not always the case for the most established ones (khan, mozaffar_2008) and certainly not for those in an inchoate state (e.g. small firms; startups). Even when considering well known debt instruments like corporate bonds which don't have a long recorded history, it is better to use alternative methods to the CAPM to compute their expected returns as the lack of sufficient data for the model would lead to unreliable valuations (singhania, 2021). Thus, at using the CAPM model it might be better for investors to be cautious about the quality of the information (e.g. betas) they use to compute their rates of return, as vicious data points might heavily undermine the robustness of their estimations

Moving forward with our analysis of the CAPM's components we get to which perhaps is its most debatable assumption: that the market is efficient. Taking for granted that today's investors act in a rational way at building their portfolios might be considered wishful thinking or even naivety. The expected return of the market in which an asset's excess return is based, is certainly affected by decisions that significantly distant from those that a financial savvy person would make. An example of this profile mismatch could be portrayed in the January 2020 events surrounding GameStop's stock when it rose more than 2000% (martin, 2021) due to the coordinated actions that thousands of retail investors undertook against "evil" hedge funds that were betting against their beloved childhood's video game store. The moral of the story is that in a public market, there is nothing that can block people up from spending their money in whichever ways they want, even if that means willingly following the opposite direction of the market's efficiency.

The aforementioned caveats should capture our attention, certainly. But that doesn't mean that the CAPM model is not really useful. For example, the CAPM serves a very important role at providing a practical and objective mechanism to estimate the cost of equity of a financial asset (mullins, 2014). This is of utmost significance for corporate financial managers that must make quick decisions in a highly dynamic environment on behalf of the companies or clients they represent. Because the CAPM is able to reconcile the risk of a security with its expected return, it is a methodology that establishes a common logical framework for agents to build rapport with shareholders and regulators. In fact, this latter group also benefits tremendously from the CAPM, providing a foundational framework upon which the fairness on the market operations can be studied by institutions like the European Securities and Markets Authority (ESMA) or the United States Securities and Exchange Commission (SEC), whose mission is "protecting investors by maintaining fair, orderly, and efficient markets" (sec, 2020). Thus, due to its strong analytical foundation and its ease of use, the CAPM is a valuable capital budgeting instrument that allow individuals to deal with the tough question of what should be the level of compensation for owning an asset and bearing its risk of ownership.

Finally, the CAPM is versatile and it is simple. The model can be extended to meet improved levels of accuracy under specific scenarios, as proposed by Fama & French with its 3-factor model to better explain the higher returns portrayed by small-cap stocks (fama, french1996) or by Wang & Chen with its conditional CAPM (wang, chen2012) to consider the effects of liquidity on the expected stock returns of a firm. In the other hand, the CAPM is easier to use than allegedly more precise but complex competing models. The Arbitrage Pricing Theory (APT) model, for instance, explains the market returns upon the linear relationship of an unlimited number of factors the (ross, 1976) which is a feature that could provide more accurate valuations. However, those factors might be macroeconomic variables that the each analyst has to choose based on his own criteria (clare, 1995), hindering methodological standardization in the open financial industry. Wrapping up, we can approach to the conclusion that the CAPM has still many years ahead. The reason being its undisputable capacity of providing an effortless mechanism to value financial assets of all types.

Net Present Value

The Net Present Value (NPV) criterion establishes a standardized way to perform capital budgeting decisions by discounting with an appropriate return rate, the streams of cash flows of a set of investments. The projects with the highest computed values should be undertaken as their financial gains outweigh the funding they require (berk, demarzo2020). The procedure is based on the concept of the Time Value of Money which basically states that money today is worth more than tomorrow. The cause of this is the compound interest paid to the owners of capital in compensation to the risk they assume when they invest in a certain opportunity upon others with similar characteristics (drake, fabozzi2009). Hence, the NPV is an straightforward calculation used by investors and managers of all types, to come across with selection decisions of financial assets in a timely and consistent way.

NPV Formula
NPV: Net Present Value Formula

However, despite its pervasiveness in industry, this procedure is not free of technical shortcomings. To begin, it might not be easy to find the appropriate cost of capital to use as discount rate, which is often computed by balancing the firm's cost of debt and cost of equity. The latter is especially challenging to obtain, especially for unlisted firms, as it is measured upon the historical correlation of the asset with the market (i.e. its beta) under debatable assumptions of perfect information and economic efficiency (dawson, peter_2015). Furthermore, the NPV method is not suitable to compare projects of different sizes as its result in monetary units is not scaled to account for the potential differing required outlays to undertake each initiative. A $1 million project might have a higher NPV than a $1000 one, but, will the company have the resources to take part in it? (nasdaq, 2015).

For that reason it is sensible to use multiple complementary capital budgeting methods for delineating a better image of the opportunities and risks associated with each project being evaluated. For example, the Payback Period method, while ignoring the Time Value of Money, is simpler and disregards many of the assumptions in which the NPV is based. Perhaps for that reason, it is the preferred method of many small and medium size businesses (alles, lakshman2020). The Internal Rate of Return (IRR), for its part, might make it easier to compare the expected performance of an asset against a company-specific target return. This computation works only for the most conventional projections without further money outlays after the project's initiation, because changes in the cash flows direction might generate multiple IRR solutions, compromising the consistency of its recommendations (osborne, michael2010). Lastly, whichever the technique applied, it is important to put our assumptions (e.g. discount rate, downpayments, forecasts) under strict scrutiny, by evaluating our models upon multiple and distinct conditions. Applying sensitiviy and break-even analysis through Monte Carlo simulation (dayananda, irons_2002) or constructing several expected scenarios, are good ways to build trust on the insights we acquire from these financial tools.

We have so far outlined the operational strengths and weaknesses that a method like the net present value brings with itself. Notwithstanding, there is much more to consider besides the monetary benefits we might get out of any chosen project. In fact, in recent years, institutional investors all across the world have grown increasingly wary about the potential effects that their decisions might have upon Environmental, Social and Governance (ESG) considerations. For instance, on a survey in 2018, 89% of South Korea's asset managers claimed they would not invest in coal-based companies in the years to come (park, so2021). Furthermore, from a portfolio perspective, it might be attractive to invest in a financial asset that doesn't yield a positive NPV, because at doing that we might be improving our level of diversification and reducing our taken risks. (dai, yuwen2021), for example, portray this kind of behaviour in the Chinese stock market, where investing in currently less profitable ESG equity indexes in addition to investing in conventional benchmark indices, have managed to increase the risk-adjusted returns.

Finally, we could be interested in making more than money with the projects we undertake. In fact, according to (the, times2021), that is the simplest definition of Ethical Investment, which represents the decisions of investors of funding projects that are Socially Responsible, care about Sustainability and aim to have a a positive Impact on the world. In doing that, one might expect that non-ethical funds would outperform their ethical equivalents, as in essence the former would be operating over less investment constraints and would not be prioritizing strict profitability measurements like the NPV. But such assumptions have been questioned by researchers like (kreander, gray2005) which in their analysis of an equal number of European ethical and non-ethical funds, found that there are not significant performance differences between the two. Therefore, after coming through the distinct investment considerations exposed in this document, we might conclude that although the Net Present Value method is a popular and practical way to make project selection decisions, there are many other perspectives that individuals can hold to choose the initiatives that better align with their particular interests.

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