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 in response to an increase in project-specific idiosyncratic risk. Moreover, these discount rate adjustments are negatively associated with measures of firm profitability and investment decision. I then explore how proxies for costly external financing and firm-level idiosyncratic risk diversification 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