Discount Rate Uncertainty and Capital Investment

Abstract

Firms obtain noisy estimates of investors’ required rates of return (discount rates) using market-based information. Discounted-cash-flow (DCF) methods as commonly taught in MBA courses lead to upward-biased estimates of project values in the presence of such noise, even when cash flow and discount rate estimates are unbiased, due to Jensen’s inequality. We show that this bias affects corporate investment decisions and firm financial performance, and we test additional predictions derived from the DCF model in the presence of noisy discount rates. Our evidence implies that a one standard-deviation increase in discount rate uncertainty is associated with increased firm investment of 8%, while profitability decreases by 4%.

Keywords: Capital Budgeting, Corporate Investment, Uncertainty, Discount Rate, Overinvestment

JEL Classification: G30, G31, G32