The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets

Source: Lintner, J. (1965). The Review of Economics and Statistics 47(1), 13–37.

TL;DR

Derives the Capital Asset Pricing Model independently of Sharpe, and works out its corporate-finance

implications: how firms should value risky cash flows and select capital-budget projects when investors

price risk through diversification. With Sharpe (1964) and Mossin (1966), it establishes the CAPM as the

equilibrium theory of risk and return.

How do risk and uncertainty affect (a) asset prices, (b) rational portfolio selection by risk-averse

investors, and (c) the proper selection of risky projects in corporate capital budgets — "under

idealized conditions"? Lintner aims to lay out the unified logical structure linking portfolio choice,

equilibrium valuation, and corporate investment decisions.

Risk-averse mean-variance investors can lend or borrow at a common riskless rate (and may sell short).

Lintner first gives a transparent proof of Tobin's separation theorem — the proportionate

composition of the risky holdings is independent of how much is held in the riskless asset — so all

investors hold the same risky portfolio (the market). Equilibrium then yields a linear risk–return

relation in which an asset's required return depends on its covariance with the rest of the market,

not its standalone variance. In modern notation: E[Rᵢ] = R_f + βᵢ(E[R_m] − R_f). He extends the same

logic to capital budgeting, where the project-acceptance problem becomes a quadratic program and the

required return reflects the project's covariance contribution to portfolio risk.

Two-fund separation: every investor holds the riskless asset plus the common market portfolio.

An asset's risk premium is proportional to its covariance with the market (its beta), not its total

variance; assets/projects whose covariance is zero are priced as if riskless.

The corporate cost of capital / project hurdle rate depends on the project's marginal contribution to

market risk, giving a covariance-based capital-budgeting rule.

Co-founds the CAPM and supplies the covariance-based cost-of-capital rule used in corporate finance

and capital budgeting.

Lintner's careful aggregation and valuation arguments complement Sharpe's portfolio derivation.

Shares the CAPM's later empirical record: the realized security market line is too flat, and size,

value, and momentum appear as CAPM alphas the model cannot explain.

Strong, idealized assumptions: single period, mean-variance preferences, homogeneous expectations,

common riskless borrowing/lending rate, frictionless markets.

The single-period, mean-variance framing abstracts from multi-period hedging and higher-moment

concerns (cf. Merton ICAPM).

Lintner, J. (1965) — The Valuation of Risk Assets... — Review of Economics and Statistics

Sharpe, W. (1964) — Capital Asset Prices — Journal of Finance

Mossin, J. (1966) — Equilibrium in a Capital Asset Market — Econometrica

Tobin, J. (1958) — Liquidity Preference as Behavior Towards Risk — Review of Economic Studies

Provenance: verified/generated from the paper's full text.