CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence

We argue that the CAPM may be a reasonable model for estimating the cost of capital for projects in spite of increasing criticisms in the empirical asset pricing literature. Following Hoberg and Welch (2007), we first show that there is more support for the CAPM than has been previously thought. We then present evidence that is consistent with the view that the option to modify existing projects and undertake new projects available to firms may be an important reason for the poor performance of the CAPM in explaining the cross section of returns on size and book-to-market sorted stock portfolios. That lends support to the McDonald and Siegel (1985) and Berk, Green and Naik (1999) observation that stock returns need not satisfy the CAPM even when the expected returns on all individual projects do. From the perspective of a person who believes that the CAPM provides a reasonable estimate of the required return on elementary individual projects, the empirical evidence in the literature is not sufficient to abandon the use of the CAPM in favor of other models.

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