With academics debating the value of the CAPM, what are companies that now use it in their capital budgeting process to do? Maybe nothing different. Obviously, capital budgeting decisions were made before there was a CAPM, and they can be made again without it. But the data seem to suggest that those who choose to use the CAPM now despite the academic debate will actually not be getting worthless advice. Recall our Chart 5, where we plotted the return/beta relationship for four types of assets over a period as long as 66 years. The result was more-or-less a positively sloped, straight line, just as the CAPM predicts. As we saw, that straight-line relationship breaks down over shorter time periods, and academics continue to debate why that is so. But for now, for those interested in the longer view, the CAPM still seems to have something to offer.

a The authors thank Jaeuk Khil for research assistance and Gordon Alexander, V. V. Chari, David Marshall, David Runkle, and especially John Boyd for helpful comments.

a The total portfolio is $1,000 invested in all stocks traded on the NYSE and AMEX.

Source: Center for Research on Security Prices, University of Chicago

Source of basic data: Ibbotson Associates 1992

GRAPH: Chart 1: How the Value of $1 Invested in Four Assets Would Have Changed Since 1926

Source of basic data: Ibbotson Associates 1992

GRAPH: Chart 2: Beta of the Stock

GRAPH: Chart 3: Standard Deviation of the Stock Return

Source of basic data: Center for Research on Security Prices, University of Chicago

GRAPH: Chart 4: A Classic Test of the CAPM

Source: Black, Jensen, and Scholes 1972

GRAPH: Chart 5: Repeating a Classic Test of the CAPM

Source: Ibbotson Associates 1992

GRAPH: Chart 6: During 1926-75

GRAPH: Chart 7: During 1976-80

GRAPH: Chart 8: During 1981-91

Source of basic data: Ibbotson Associates 1992

GRAPH: Chart 9: A Standard One-Beta Model

GRAPH: Chart 10: A Model With Human Capital and Time-Varying Betas..

GRAPH: Chart 11: . . . And Firm Size

Source: Jagannathan and Wang, forthcoming (Figures 1, 3, and 4)

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By Ravi Jagannathan, Visitor, Research Department, Federal Reserve Bank of Minneapolis and Piper Jaffray Professor of Finance Carlson School of Management University of Minnesota and Ellen R. McGrattan, Senior Economist, Research Department, Federal Reserve Bank of Minneapolis

Models like the capital asset pricing model (the CAPM) help corporate managers by providing them with a practical way to learn about how investors judge the riskiness of potential investment opportunities. This helps managers use the sources of their firms more efficiently.

In modern industrial economics, managers don't easily know what the firm's owners want them to do. Ownership and management are typically, quite separate. Managers are hired to act in the interests of owners, who bold stock in the corporation but are otherwise not involved in the business.

Owners send some general messages to managers through the stock market. If stockholders do not like what managers are doing, they sell their stocks, and the market value of the firm's stock drops. The representatives of stockholders on the firm's board of directors notice this and turn to the managers for corrective action. In this way, therefore, stock prices act like an oversight mechanism. They monitor the activities of managers by aggregating the opinions of the stockholders.

However, stock prices don't act fast enough. They don't give managers specific directions ahead of time about which projects to pursue and which to avoid. Managers must make these capital expenditure decisions on their own and then later find out, by the stock market's reaction, whether or not the firm's owners approve.

Disapproval can be costly. In the United States in 1992, for example, capital expenditures by the corporate business sector (excluding farming and finance) totaled $397 billion (or 6.6 percent of the annual gross domestic product). These expenditures usually cannot be recovered if stockholders disapprove of them.

In view of this, capital budgeting has a central role in both the theory and the practice of managerial finance.

Theory suggests one simple nile for corporate managers to follow when making capital expenditure decisions: Maximize the value of the firm. Then, if some stockholders disagree with management decisions, they can sell their stock and be at least as well off as if management had made different decisions. This idea is the basis for the classic theoretical recommendation that managers only invest in those projects which have a positive net present value.

In practice, however, following that simple role is not simple. It requires, among other things, estimating the net present value of every project under consideration. Corporations thus spend a substantial amount of resources evaluating potential projects.

A key input to that process is the cost to the firm of financing capital expenditures, known more simply as the cost of capital. This is the expected rate of return that investors will require for investing in a specific project or financial asset. The cost of capital typically depends on the particular project and the risk associated with it. To be able to evaluate projects effectively, managers must understand how investors assess that risk and how they determine what risk premium to demand.

Providing such an understanding is the focus of most research in the area of asset pricing. An asset pricing model provides a method of assessing the riskiness of cash flows from a project. The model also provides an estimate of the relationship between that riskiness and the cost of capital (or the risk premium for investing in the project).

According to the CAPM, the only relevant measure of a project's risk is a variable unique to this model, known as the project's beta. In the CAPM, the cost of capital is an exact linear function of the rate on a risk-free project and the beta of the project being evaluated. A manager who has an estimate of the beta of a potential project can use the CAPM to estimate the cost of capital for the project.

If the CAPM captures investors' behavior adequately, then the historical data should reveal a positive linear relation between the average rerum on financial assets and their betas. Also, no other measure of risk should be able to explain the differences in average returns across financial assets that are not explained by CAPM betas. Empirical studies of the CAPM have supported tiffs model on both of those points -- recently, as the accompanying article describes.

The article is great!!

but can you post the chart and figure ?