Capital Budgeting and Idiosyncratic Risk

80 Pages Posted: 17 Nov 2019 Last revised: 21 Jan 2024

See all articles by Paul H. Décaire

Paul H. Décaire

Arizona State University (ASU) - Finance Department

Date Written: January 19, 2024

Abstract

Using a NPV-based revealed-preference strategy, I find that managers increase the discount rate used in capital budgeting decisions upward to account for idiosyncratic risk. To establish causality, I exploit quasi-exogenous within-region variation in project-specific idiosyncratic risk. I then decompose the measure of idiosyncratic risk into a good and a bad component and show that discount rate adjustments appear to penalize exposure to downside risk. Finally, I explore how costly external financing, internal monitoring frictions, and CEOs' personal exposure to idiosyncratic risk affect those adjustments. Overall, financial and operational frictions induce managers to account for idiosyncratic risk when computing discount rates.

Keywords: Capital Budgeting, Discount rate, Idiosyncratic Risk, Corporate Investment, Risk Management, Governance

JEL Classification: G30, G31, G32

Suggested Citation

H. Décaire, Paul, Capital Budgeting and Idiosyncratic Risk (January 19, 2024). Available at SSRN: https://ssrn.com/abstract=3480884 or http://dx.doi.org/10.2139/ssrn.3480884

Paul H. Décaire (Contact Author)

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

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