Learning about Discount Rates

Abstract

Using valuation reports disclosing managers’ expectations of cashflow growth (g) and discount rates (k) in M&A transactions, we examine what they learn from target stock prices. Before correcting for endogeneity, both appear sensitive to prices—positively for g, negatively for k, and with equal magnitude—suggesting managers learn about both. However, using noise in prices as an instrument, only k reacts—with corrected estimates indicating that 89% of managers’ information about k comes from prices. Therefore, stock markets inform managers about risk and the compensation it requires, but not cashflows, which they already understand well. Cross-sectional tests reinforce this conclusion.

Keywords: Managerial Learning, Market Feedback Effects, Cash Flow Expectations, Return Expectations, Discount Rates, Capital Budgeting

JEL Classification: D84, G14, G17, M41