CAPM Based Misvaluation Flashcards
Why does the CAPM lead to systematic mispricing in M&A transactions?
CAPM misprices risk by underestimating returns for low-beta firms and overestimating them for high-beta firms, leading acquirers to overpay for low-beta targets and underpay for high-beta ones.
What percentage of deal values do CAPM-based misvaluations typically represent?
Valuation errors due to CAPM reliance in M&A deals range from 12% to 33% of total deal values.
How does the empirical Security Market Line (SML) differ from the one predicted by CAPM?
The empirical SML is flatter than the CAPM-implied SML, meaning low-beta stocks generate higher-than-expected returns while high-beta stocks underperform CAPM predictions.
Why do firms continue to use CAPM despite its empirical flaws?
CAPM is widely taught in academia and remains the dominant framework for estimating the cost of capital, despite empirical evidence suggesting it systematically misestimates returns.
How does CAPM mispricing affect capital budgeting decisions?
Managers using CAPM for capital budgeting tend to overvalue low-beta projects and undervalue high-beta projects, leading to inefficient investment decisions.
How does CAPM misvaluation manifest in mergers and acquisitions (M&A)?
Acquirers using CAPM tend to overbid for low-beta private firms, resulting in lower cumulative abnormal returns (CARs) for bidders, while high-beta acquisitions receive more favorable market reactions.
What is the estimated effect of CAPM misvaluation on bidder cumulative abnormal returns (CARs)?
A difference in target betas of one interquartile range (0.49) is associated with a difference in bidder CARs of 0.5 to 1.2 percentage points, equating to 6% to 16% of the interquartile range of bidder CARs.
What alternative valuation models may provide better risk-adjusted return estimates than CAPM?
Multifactor models, such as Fama-French, or valuation methods based on option prices, may better capture risk-adjusted return expectations compared to CAPM.
What evidence suggests that managers relying on CAPM are making valuation errors?
Empirical findings show no long-term return reversal, indicating that CAPM mispricing leads to real misallocations of capital rather than temporary market inefficiencies.
How does corporate governance impact the reliance on CAPM for valuation?
Stronger corporate governance reduces reliance on CAPM, as well-governed firms are more likely to adopt alternative valuation models that better reflect risk-adjusted returns.
Why should adjustments be made when using CAPM for valuation?
CAPM remains a useful starting point, but adjustments—such as shrinking beta estimates or incorporating additional factors—are necessary to correct systematic mispricing.
Beyond M&A, how does CAPM-based misvaluation affect broader corporate investment decisions?
CAPM mispricing extends to general capital budgeting decisions, influencing project selection and potentially leading to inefficient capital allocation.
How do market reactions confirm the CAPM-based misvaluation hypothesis?
Market reactions to M&A transactions show that bidders of low-beta targets experience lower cumulative abnormal returns.
What empirical strategy did the authors use to confirm CAPM-driven misvaluation in M&A?
The study used M&A data and regression analysis to link target beta levels with bidder CARs, showing a statistically significant relationship between CAPM mispricing and market reactions.
How do firms with high beta targets tend to be priced compared to CAPM predictions?
High-beta targets tend to be undervalued compared to CAPM predictions, leading to relatively lower bid premiums and higher market approval of these acquisitions.
What role does the use of fairness opinions play in CAPM-based misvaluation?
Fairness opinions often rely on CAPM-based discount rates, reinforcing the valuation distortions by applying misestimated costs of capital to acquisition targets.
What are the normative implications of CAPM-based misvaluation?
If the market is efficient and CAPM misestimates risk, firms using CAPM make systematic valuation mistakes, suggesting that corporate decision-makers should incorporate alternative models.
