Evaluating risky projects: going beyond CAPM-NPV

Time: 2011, Wednesday March 23, 13.00-14.00 hours
Location: CPB-office, Van Stolkweg 14, The Hague

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Presentation: Rob Aalbers (CPB)

Discussant: Arjen Gielen (Ministry of General Affairs)

Language: English

Registration: Please register by sending an email to seminars@cpb.nl.

Abstract subject: Cost-benefit analysis requires an exogenous source of information, such as the Capital Asset Pricing Model (CAPM), to determine a project's risk. Under CAPM, project risk is determined by the covariance between the rates of return of the project and the market. We argue that CAPM may systematically misrepresent project risk, in particular of adaptation and mitigation, thereby misguiding decision makers under any of the following three conditions. One, the project's systematic risk is not constant over its lifetime. Two, investors do not only care about end-of-period wealth. Three, the project changes the market price of risk. We provide examples of projects whose risk is likely to be misrepresented by CAPM and discuss possible remedies, such as real options, and dynamic stochastic general equilibrium (DSGE) models. In addition, we discuss the informational requirements of these models vis-à-vis CAPM-NPV. We conclude with discussing several rules of thumb.

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