The cross-section of hurdle rates for capital budgeting

Description

"Whereas Poterba and Summers (1995) find that firms use hurdle rates that are unrelated to their CAPM betas, Graham and Harvey (2001) find that 74% of their survey firms use the CAPM for capital budgeting. We provide an explanation for these two apparently contradictory conclusions. We find that firms behave as though they add a hurdle premium to their CAPM based cost of capital. Following McDonald and Siegel (1986), we argue that the hurdle premium depends on the value of the option to defer investments. While CAPM explains only 10% of the cross-sectional variation in hurdle rates across firms, variables that proxy for the benefits from the option to wait for potentially better investment opportunities explain 35%. Estimates of our hurdle premium model parameters imply an equity premium of 3.8% per year, a figure that is essentially the same as that reported in the survey by Graham and Harvey (2005). Consistent with our model, growth firms use a higher hurdle rate when compared to value firms, even though they have a lower cost of capital"--National Bureau of Economic Research web site.

Subjects

Series Statement

• NBER working paper series -- working paper 16770
• Working paper series (National Bureau of Economic Research : Online) -- working paper no. 16770.

Links

• http://www.nber.org/papers/w16770