Capital Budgeting and Idiosyncratic Risk

Abstract

Using an NPV-based revealed-preference strategy, I find that idiosyncratic risk affects the discount rate that firms use in their capital budgeting decisions. I exploit quasi-exogenous within-region variation in project-specific idiosyncratic risk and find that firms inflate their discount rate by 5 percentage points (pp) in response to an 18pp increase in idiosyncratic risk. Moreover, these discount rate adjustments are negatively associated with measures of firm profitability. I then explore how proxies for costly external financing and agency frictions relate to discount rate adjustments. Consistent with theoretical predictions, firms appear to adjust their discount rate to account for both frictions.

Keywords: Capital Budgeting, Corporate Investment, Empirical Corporate Finance, Risk Management

JEL Classification: G30, G31, G32