engleski

Adequacy of the CAPM for Estimating the Cost of Equity Capital: Empirical Study on Underdeveloped Market

When evaluating investment projects, an appropriate discount rate needs to be estimated, which is often represented by the weighted average cost of capital (WACC). Furthermore, when estimating the cost of equity capital, the Capital Asset Pricing Model (CAPM) is usually used. With the aim of testing and analyzing the possibility of applying the CAPM model to making capital budgeting decisions in underdeveloped markets, the authors conducted research on a sample of 62 randomly selected project proposals generated in the period from 2003 to 2014 and planned to be implemented in Eastern Croatia. Through this research, cash flows, profitability, and the investment structure of the projects were analyzed and put into relation with profitability of the investment in a created stock portfolio. The results showed that, when using the CAPM in underdeveloped markets, certain adjustments in defining calculation input values are needed in order to get relevant output information. Even without the specificities of underdeveloped markets, the use of the CAPM is still not without controversies. The questions regarding beta calculation, a premium market rate and an adequate risk-free rate, are still being discussed. Nevertheless, it was found that the CAPM could give a satisfactory insight into investors’ minimum required returns and the riskiness of investment options. The authors emphasize that investors must not ignore the shortcomings of this model regarding the characteristics of capital markets it was tested on, the specificities of the industry being invested in and the fact that the CAPM model strongly responds to highly variable cash flows and a project period to achieve full production capacity.

capital investments ; CAPM ; decision making ; management ; risk analysis

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