Economic profit, NPV, and CAPM: Biases and violations of Modigliani and Miller's Proposition I

The notion of Net Present Value (NPV) is thought to formally translate the notion of economic profit, where the discount rate is the cost of capital. The latter is the expected rate of return of an equivalent-risk alternative that the investor might undertake and is often found by making recourse to the Capital Asset Pricing Model. This paper shows that the notions of disequilibrium NPV and economic profit are not equivalent if the standard NPV+CAPM is employed: NPV-minded agents are open to framing effects and to arbitrage losses, which imply violations of Modigliani and Miller's Proposition I. The standard notion of disequilibrium (present) value, deductively derived from the CAPM by several authors, should therefore be dismissed.