Abstract - Asset-Class Based Capital Budgeting

Fama and French (1997) show that the CAPM and FFM (Fama-French XMKT, HML, SMB model) have large standard errors in one-month-ahead forecasts. Our paper extends their perspective. It shows that both models have no out-of-sample predictive ability over multi-months horizons. This is not just due to factor premia uncertainty, but due to high variability and mean reversion of (shrunk industry) factor loadings. Our findings are robust to a broad range of estimation procedures. In sum, the evidence suggests that corporate executives are better off not using the CAPM or FFM models to infer differential opportunity costs of equity capital for longer-term projects. Under the reasonable hypothesis that fixed-income securities have lower expected rates of return than equity securities, the logical conclusion is that managers should calculate project costs of capital based only on how levered their projects are. We call this asset-class based capital budgeting (ABC).

Ivo Welch
UCLA Anderson School of Management
27.Jun 2012

Back to overview