Why Do Firms Use High Discount Rates?
Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad
David A. Matsa
Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)
HEC Montreal - Department of Finance
Loyola University of Chicago - School of Business Administration; Northwestern University - Kellogg Graduate School of Management
June 8, 2014
We find that firms use discount rates for capital budgeting that are on average twice their cost of financial capital, based on an original survey of CFOs with firm identifiers linked to responses. Under the standard corporate finance paradigm, firms take all projects that return more than their cost of financial capital unless they are constrained. We explore the nature of the constraints that lead firms to increase their discount rates. Firms that use high discount rates relative to their cost of financial capital have strong balance sheets, low leverage, and large cash holdings. These firms appear to be conserving managerial bandwidth and manpower by forgoing good projects while preparing for even better investment opportunities to arise. This is consistent with their response that they are facing operational constraints but not financial constraints. CAPM and WACC explain the cross-section of discount rates after we control for limited managerial bandwidth.
Number of Pages in PDF File: 78
Keywords: Capital budgeting; discount rates; cost of capital
JEL Classification: G31; G32
Date posted: March 22, 2014 ; Last revised: June 9, 2014
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