The Cross-Section of Hurdle Rates for Capital Budgeting: An Empirical Analysis of Survey Data
Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); SAIF; ISB
HEC Montreal - Department of Finance
Loyola University of Chicago - School of Business Administration; Northwestern University - Kellogg Graduate School of Management
NBER Working Paper No. w16770
Whereas Poterba and Summers (1995) find that firms use hurdle rates that are unrelated to their CAPM betas, Graham and Harvey (2001) find that 74% of their survey firms use the CAPM for capital budgeting. We provide an explanation for these two apparently contradictory conclusions. We find that firms behave as though they add a hurdle premium to their CAPM based cost of capital. Following McDonald and Siegel (1986), we argue that the hurdle premium depends on the value of the option to defer investments. While CAPM explains only 10% of the cross-sectional variation in hurdle rates across firms, variables that proxy for the benefits from the option to wait for potentially better investment opportunities explain 35%. Estimates of our hurdle premium model parameters imply an equity premium of 3.8% per year, a figure that is essentially the same as that reported in the survey by Graham and Harvey (2005). Consistent with our model, growth firms use a higher hurdle rate when compared to value firms, even though they have a lower cost of capital.
Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
Number of Pages in PDF File: 43working papers series
Date posted: February 7, 2011
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo6 in 0.641 seconds