Capital Budgeting: A 'General Equilibrium' Analysis

Abstract

As presented in leading corporate finance textbooks the predominant method for making capital budgeting decision is discounted cash flow analysis. The primary benefit of this approach is that it allows for different discount rates to be used for different projects. In this paper, I argue that this alleged benefit is, in fact, a detriment for two reasons. First, the betas that determine the differing discount rates are not only measured with significant error, but tend to drift substantially over the life of typical capital budgeting projects. Second, introducing differential discount rates is likely to conflict with other “general equilibrium” management objectives related to developing a successful corporate culture that promotes collaboration and innovation. This explains why many companies, particularly companies that have a large number of growth options, choose alternatives to discounted cash flow such as the internal rate of return.

Keywords: capital budgeting, discount rates

JEL Classification: G31