How an idiosyncratic (zero-beta) risk can greatly increase the firm’s cost of capital

Andrew Grant, David Johnstone and Oh Kang Kwon
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Andrew Grant: The University of Sydney, Sydney, NSW, Australia
David Johnstone: University of Wollongong, Wollongong, NSW, Australia
Oh Kang Kwon: The University of Sydney, Sydney, NSW, Australia

Australian Journal of Management, 2022, vol. 47, issue 4, 664-685

Abstract: The celebrated capital asset pricing model (‘CAPM’) brought numerous appealing insights and spawned a new theory of capital budgeting. One key intuition is that there is ‘no penalty for diversifiable risk’ – that is, any risky payoff that has zero-correlation with the wider economy, and hence zero-beta, is treated as ‘risk-free’. Does that mean that managers can bet the firm on a spin of the roulette wheel without attracting a higher CAPM discount rate? Our re-interpretation of CAPM reveals that potential financial losses which are conventionally regarded as firm-specific ‘unpriced’ risks can bring a large increase in the firm’s beta and CAPM cost of capital, despite having zero-beta and making only negligible difference at the aggregate market level. This mathematical result clashes with textbook expositions but is easily demonstrated and can be traced to authoritative but overlooked parts of the theoretical CAPM literature. JEL Classification: G11, G12

Keywords: CAPM; cost of capital; priced diversifiable risk (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:sae:ausman:v:47:y:2022:i:4:p:664-685

DOI: 10.1177/03128962211059576

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