Discount Rate Uncertainty and Capital Investment

56 Pages Posted: 7 Dec 2020 Last revised: 8 Jan 2021

See all articles by Hendrik Bessembinder

Hendrik Bessembinder

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

Paul H. Décaire

Arizona State University (ASU) - Finance Department

Date Written: January 7, 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 6.8%, while profitability decreases by 4.1%.

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

JEL Classification: G30, G31, G32

Suggested Citation

Bessembinder, Hendrik (Hank) and H. Décaire, Paul, Discount Rate Uncertainty and Capital Investment (January 7, 2020). Available at SSRN: https://ssrn.com/abstract=3723936 or http://dx.doi.org/10.2139/ssrn.3723936

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

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

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