Capital Budgeting and Idiosyncratic Risk

91 Pages Posted: 17 Nov 2019 Last revised: 3 Dec 2019

See all articles by Paul H. Décaire

Paul H. Décaire

University of Pennsylvania, The Wharton School

Date Written: December 1, 2019

Abstract

Using an NPV-based revealed-preference strategy, I find that idiosyncratic risk materially 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, on average, firms inflate their discount rate by 5 percentage points (pp) in response to an 18 pp increase in idiosyncratic risk. Moreover, these discount rate adjustments are negatively associated with various measures of firm profitability. I then explore how proxies for costly external financing and agency frictions relate to discount rate adjustments. I find that firms appear to adjust their discount rate upward as a form of risk management when facing costly external financing frictions. Also, I provide evidence that firms partially insure managers against project-specific underperformance to mitigate discount rate adjustments due to agency frictions.

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

JEL Classification: G30, G31, G32

Suggested Citation

H. Décaire, Paul, Capital Budgeting and Idiosyncratic Risk (December 1, 2019). Available at SSRN: https://ssrn.com/abstract=3480884 or http://dx.doi.org/10.2139/ssrn.3480884

Paul H. Décaire (Contact Author)

University of Pennsylvania, The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://www.pauldecaire.com

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