Single vs. Multiple Discount Rates: How to Limit 'Influence Costs' in the Capital Allocation Process

Posted: 11 Sep 2008

See all articles by John D. Martin

John D. Martin

Baylor University - Department of Finance, Insurance & Real Estate

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

Date Written: September 9, 2008

Abstract

A widely cited survey of financial executives reported that more than 50% of the surveyed companies used a single, company-wide discount rate to evaluate all investment proposals. The shortcomings of this approach are well known and reported in virtually every introductory finance text. Yet despite technological improvements and the legions of MBAs who are fully aware of the importance of matching project risk with risk-adjusted discount rates, corporate executives tend to prefer evaluating investment opportunities using very simple approaches that provide managers with very few degrees of freedom.

In this article we discuss political and organizational problems that tend to discourage the use of multiple discount rates. More importantly, we provide a relatively straightforward method for choosing discount rates that captures much of the differences in the risk of individual investment projects while at the same time limiting the effect of these organizational impediments to risk-adjusted capital budgeting.

Keywords: Cost of Capital, Influence Costs

JEL Classification: G31

Suggested Citation

Martin, John D. and Titman, Sheridan, Single vs. Multiple Discount Rates: How to Limit 'Influence Costs' in the Capital Allocation Process (September 9, 2008). Available at SSRN: https://ssrn.com/abstract=1265732 or http://dx.doi.org/10.2139/ssrn.1265732

John D. Martin (Contact Author)

Baylor University - Department of Finance, Insurance & Real Estate ( email )

P.O. Box 98004
Waco, TX 76798-8004
United States
254-710-4473 (Phone)
254-710-1092 (Fax)

HOME PAGE: http://hsb.baylor.edu/html/martinj

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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