What Works Best in Capital Budgeting?

42 Pages Posted: 24 Apr 2021 Last revised: 7 Sep 2021

See all articles by Nicolas Hommel

Nicolas Hommel

Princeton University

Augustin Landier


David Thesmar

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: April 16, 2021


To compute the value of a project, the baseline textbook recommendation is to use the Present Value (PV) formula of expected cash-flows, with a discount rate based on the CAPM. In this paper, we ask what is, empirically, the best discounting method. To do this, we study listed firms, whose expected cash-flows are measured through EPS forecasts, and whose actual prices are observed. We compare different discounting approaches of computing the PV. Our metric is the ability of each discounting approach to predict actual market prices. We find that discounting with an imputed Internal rate of return (IRR), computed on comparable firms, obtains very good results. Discounting based on expected returns (such as the CAPM or multi-factor), or a simple multiple approach, performs less well. Significant, but small, improvements can be obtained by allowing, in a simple and actionable way, for a more flexible term structure of expected returns. We benchmark all of our results with flexible, purely statistical models of prices based on Random Forest algorithms. These models do barely better than our preferred, NPV-based methods.

Keywords: Valuation, Present Value Formula, IRR

JEL Classification: G31, G32

Suggested Citation

Hommel, Nicolas and Landier, Augustin and Thesmar, David, What Works Best in Capital Budgeting? (April 16, 2021). Available at SSRN: https://ssrn.com/abstract=3827511 or http://dx.doi.org/10.2139/ssrn.3827511

Nicolas Hommel

Princeton University ( email )

United States

Augustin Landier

HEC ( email )

+33630006051 (Phone)

HOME PAGE: http://https://sites.google.com/site/augustinlandier/

David Thesmar (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
Cambridge, MA 02142
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

United Kingdom

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