The United Kingdom's Companies Act of 2006 and the capital asset pricing model: Attaining the corporate objective

The purpose of this paper is to consider the attainment of the corporate objective of the UK Companies Act of 2006 Section 172(1) from the perspective of financial valuations that are reliant on the cost of capital. The cost of capital plays an important role in many of the models and propositions that are routinely used for financial valuation and decision making.

From the perspective of financial valuations that are used to guide decision making that is in accordance with the corporate objective of the UK Companies Act of 2006 Section 172(1), managers and directors require a valid, reliable, and interpretable cost of capital. The theory, models, and propositions of financial management, whether they be investment, financing, or distributions (Sections 829‐853) decisions, are dependent on the cost of capital. This paper has three main tasks. First, the relevant sections of UK corporate statute with regard to the corporate objective need to be identified and presented. Second, a brief review of the function and role of the cost of capital for the valuations upon which investment, financing, and dividend decisions are based, is undertaken to ensure that the role and function of this key financial metric is clearly recognized. Third, since the capital asset pricing model (CAPM) is so widely and exclusively used, often without recourse to other approaches to calculation of the cost of capital, an update of CAPM empirical evidence is undertaken to affirm the 2004 findings and subsequent recommendations by Fama and French that the CAPM is not an acceptable way of calculating the cost of capital.

It is doubtful whether directors, who use an empirically invalid and unreliable valuation model such as the CAPM to calculate the cost of capital, will be able to meaningfully and purposefully make decisions consistent with the “enlightened shareholder value”. Managers and directors need to use approaches to the cost of capital that are valid and can be empirically verified.

This paper recommends that directors of public companies who make decisions using financial valuations that embody the cost of capital should ensure that models other than the CAPM are used; otherwise, they may find it difficult unable to defend challenges to their statutory duty of attaining the corporate objective.

An update of CAPM empirical evidence is undertaken to affirm the findings and subsequent recommendations by Fama and French (2004) that the CAPM is not an acceptable way of calculating the cost of capital.