Discount Rate Uncertainty and Capital Investment

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See all articles by Paul H. Décaire

Paul H. Décaire

Arizona State University (ASU) - Finance Department

Hendrik Bessembinder

Arizona State University; W.P. Carey School of Business

Date Written: November 18, 2020

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

Suggested Citation

H. Décaire, Paul and Bessembinder, Hendrik (Hank), Discount Rate Uncertainty and Capital Investment (November 18, 2020). Available at SSRN: https://ssrn.com/abstract=

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

Hendrik (Hank) Bessembinder

Arizona State University ( email )

PO Box 873906
Tempe, AZ 85207
United States

W.P. Carey School of Business ( email )

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

HOME PAGE: http://https://wpcarey.asu.edu/people/profile/2717225

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