It is often argued that companies should accept projects with positive net present value as it increases shareholder value. The net present value is typically calculated by discounting expected cash flows with a risk-adjusted cost of capital that reflects the project's systematic risk. In financial textbooks, usually the Capital Asset Pricing Model (CAPM) or the Fama-French 3-Factor Model (FFM3) is recommended to calculate the cost of equity, and studies show that they are the most widely used models in practice (Bruner et al, 1998), (Graham and Harvey, 2001) and (PWC, 2016). The purpose of this thesis is to investigate whether it is useful for companies to use CAPM and FFM3 for investment decisions or whether the models are too imprecise. The analysis is based on US stocks returns and financial data from the Center for Research in Security Prices (CRSP), NYSE, AMEX and NASDAQ for the period 1963-2019. The thesis concludes that estimates of cost of equity are extremely imprecise when based on historical data. For industries, standard errors of more than 2% per year are typical for both CAPM and FFM3. These large standard errors are the result of i) uncertainty about true factor risk premiums and ii) imprecise estimates of factor loadings. For companies and projects, uncertainty will only be greater. Based on these findings, the thesis argues that precision should not be the ultimate success criterion for companies' choice of decision method. Companies should not choose projects blindly, but neither should they write off the payback method or the more subjective fundamental analysis or forwardlooking methods. However, the decision-making method is of great importance for companies’ investment policies, and on a par with the distribution policy, it should be relevant information for shareholders. It is hardly detrimental for the companies to state in the annual report whether they use CAPM based on few years of data or a completely different approach. In this way, the individual investor will be able to get an idea of the size of the cost of equity used by the company and decide whether he agrees with the methods used.
|MSc in Finance and Accounting, (Graduate Programme) Final Thesis
|Number of pages