The Cross-Section of Hurdle Rates for Capital Budgeting: An Empirical Analysis of Survey Data

43 Pages Posted: 7 Feb 2011

See all articles by Ravi Jagannathan

Ravi Jagannathan

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

Iwan Meier

HEC Montreal - Department of Finance

Vefa Tarhan

Loyola University of Chicago - School of Business Administration; Northwestern University - Kellogg Graduate School of Management

Date Written: February 2011

Abstract

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.

Suggested Citation

Jagannathan, Ravi and Meier, Iwan and Tarhan, Vefa, The Cross-Section of Hurdle Rates for Capital Budgeting: An Empirical Analysis of Survey Data (February 2011). NBER Working Paper No. w16770. Available at SSRN: https://ssrn.com/abstract=1754921

Ravi Jagannathan (Contact Author)

Northwestern University - Kellogg School of Management ( email )

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Evanston, IL 60208
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847-491-8338 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

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Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
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Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

Iwan Meier

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7 H2J 2K9
Canada
(514) 340-3198 (Phone)

Vefa Tarhan

Loyola University of Chicago - School of Business Administration ( email )

820 North Michigan Avenue
Chicago, IL 60611
United States

Northwestern University - Kellogg Graduate School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

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