Replacing Modern Portfolio Theory
Via The Aleph Blog:
I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:
- Beta is not a stable parameter; also, it does not measure risk well.
- Company-specific risk is significant, and varies a great deal. The effects on a company with a large amount of debt financing is significant.
What did they do in the old days? They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks. If less scientific, it was probably more accurate than MPT. Science is often ill-applied to what may be an art. Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.
I’ve also never been a fan of the Modigliani-Miller irrelevance theorems. They are true in fair weather, but not in foul weather. The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency. The cost of financing assets goes up dramatically when a company needs financing in bad times.
Read the full post here
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