Fundamental (versus Market) Risk and Capital Budgeting Decisions: Distinguishing between the Investment Hurdle Rate and the Cost of Capital
37 Pages Posted: 17 Aug 2017
Date Written: June 2017
Employing a basic model of an economy comprising both the real and financial sectors, I show that the primitive risk measure for real investment decisions is earnings beta — defined as the (normalized) covariance between firm profitability (return on investment) and the aggregate profitability of all firms in the economy, not market beta. Earnings beta determines the risk premium required to convert a project’s risky cash flow to its certainty equivalent and is the basis for setting the hurdle rate for project selection. Earnings beta is also the origin of market beta for asset pricing, but the mapping of earnings beta into market beta is intervened by the profitability level of the underlying project. For a given earnings beta, a firm with higher expected profitability (hence higher market value) has a smaller market beta because investors holding the firm’s stock bear a smaller fraction of total firm risk per unit of investment capital they contribute. I show that the optimal hurdle rate for project selection which maximizes investor wealth is different from the cost of capital concerning a specific project except when the project has zero net present value. Finally, I demonstrate that the standard capital budgeting techniques prescribed in textbooks and widely adopted in practice — which are centered on the notion of market risk rather than fundamental risk — cause suboptimal decisions, and I offer remedies to correct the misvaluation problems.
Keywords: Earnings Beta, Market Beta, Capital Budgeting, Investment Hurdle Rate, Cost of Capital, Capital Asset Pricing Model (CAPM)
JEL Classification: G12, G31, M41
Suggested Citation: Suggested Citation