282 NPV PROBABILITY DISTRIBUTION OF RISKY INVESTMENTSundiversifiable rate of return variance. Volatility of stock returns and risk
became conceptual equivalents for the academic community. However, such
a definition of risk runs counter to the everyday and commonly understood
dictionary definition of risk. Risk is generally associated with the probability
of occurrence of an undesirable event, for example, the probability of loss.
One might then very well argue the CAPM has adopted a surrogate measure
of risk which does not fit well in a world where the actual risk of default is
very real.
15.3 TOTAL RISK AND THE REAL ECONOMY
Under the Modigliani–Miller (MM) paradigm, the economy is completely
transparent and frictionless. A transparent economy implies that all eco-
nomic agents share the same information and that there does not exist
informational asymmetries between various stakeholders, such as cur-
rent shareholders, debtholders, future shareholders, managers, suppliers,
employees and customers among others. A frictionless economy means
that the economy adjusts instantaneously and costlessly (no transaction or
default costs) and that its workings are not hampered by various material,
financial, managerial or organizational constraints. Consequently, financing
an investment project through debt or equity is irrelevant in a MM econ-
omy. This explains why a project’s value is the same irrespective of the firm
that undertakes it or of its contribution to the firm’s total risk. All valuable
investment projects can be financed whatever the firm’s financial position.
A similar type of reasoning is adopted under the CAPM efficient mar-
ket hypothesis as shareholders are assumed to be investing directly into a
project providing a required rate of return satisfying the one-period efficient
market equilibrium conditions. Again, the economy is transparent and fric-
tionless. Such a rule has been proposed and adopted by academics for over
40 years even though Eugene Fama’s article (1970) demonstrates that the
CAPM formula cannot generally be used for discounting cash flows in a
multi-period framework. The CAPM decision rule states that any invest-
ment project with a positive expected NPV should be accepted, irrespective
of its own volatility or of its contribution to the firm’s total risk, for only sys-
tematic risk is relevant. We may qualify such a point estimate or certainty
equivalent approach as normative to the extent that market conditions under
which the investment process is taking place as well as the required rate of
return both represent idealised conditions and are not at all descriptive of
the actual workings of the real economy. Obviously, the proposed CAPM
certainty equivalent evaluation and decision rule aim at determining the
market value of an investment project. However, the market to which it is
referring is the one of a one-period transparent and frictionless economy
abiding by the Modigliani–Miller paradigm. In the very same sense, the