Working Paper: CEPR ID: DP18221
Authors: Niels Joachim Gormsen; Kilian Huber
Abstract: Standard theory implies that the discount rates used by firms in investment decisions (i.e., their required returns to capital) determine investment and transmit financial shocks to the real economy. However, there exists little evidence on how firms’ discount rates change over time and affect investment. We construct a new global database based on manual entry from conference calls. We show that, on average, firms move their discount rates with the cost of capital, but the relation is far below the one-to-one mapping assumed by standard theory, with substantial heterogeneity across firms. This pattern leads to time-varying wedges between discount rates and the cost of capital. The average wedge has increased substantially over the last decades as the cost of capital has dropped. Future investment is negatively related to discount rate wedges, but more weakly related to the cost of capital because of the limited transmission into discount rates. Moreover, the large and growing discount rate wedges can account for the puzzle of "missing investment" (relative to high asset prices) in recent decades. We find that beliefs about value creation combined with market power, along with fluctuations in risk, explain changes in discount rate wedges over time.
Keywords: Corporate Investment; Discount Rate; Cost of Capital; Required Return to Capital; Market Power; Risk
JEL Codes: E22; E32; E43; E44; E52; G10; G12; G30; G31; G40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in average discount rate wedge from 2002 to 2021 (E43) | understanding of dynamics of corporate investment (G31) |
| increase in the wedge between discount rates and perceived cost of capital (G19) | decrease in investment rates (E22) |
| changes in perceived cost of capital (G32) | changes in discount rates (E43) |
| discount rates (E43) | investment decisions (G11) |