Introduction
When an industry settles into a long-term competitive equilibrium, all assets are expected to earn their opportunity cost of capital because any economic profits have already been driven away by competition in the industry in terms of expansion by existing firms or entrance by new firms. However, the Long-term equilibrium is not a static point, but rather it is a dynamic process in which the equilibrium is constantly changing. In this process, firms enjoy economic profits due to either industry characteristics, such as industry concentration and industry-level barrier to entry, or firm characteristics, such as monopoly power and competitive advantages. It is because of economic profits that we advocate the use of the discounted cash flow analysis in capital budgeting to look for projects with positive net present values (Brealey and Myers, 2000). Thus, the existence of economic profits does not contradict the EMH as long as stock price fully reflects fundamental information about a firm’s earnings generating ability such that at a particular time an investor cannot earn an abnormal return from a stock investment (Kothari, 2001).
The CAPM only assumes efficient portfolios; it is not the same concept as the EMH. Although market-based event studies in accounting and finance generally assume the descriptive validity of both the EMH and the CAPM, the CAPM does not have to be maintained in an association study, where raw stock return is used as the dependent variable.
Even with the existing evidence often cited by critics, one cannot rule out the CAPM as the asset pricing model that still enjoys the broadest support in both the academic and the practicing community. The bottom line is that there is no widely accepted alternative model for computing expected returns. This explains why the CAPM continues to dominate capital markets research in accounting and finance.
This study attempted to investigate the use of the capital asset pricing model in order to explain the discount rate and how it affects the discount rate of return. Specifically, it shall address the issue of discrepancy in the rate of return between large and small companies.
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