Working Paper: NBER ID: w16770
Authors: Ravi Jagannathan; Iwan Meier; Vefa Tarhan
Abstract: 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.
Keywords: hurdle rates; capital budgeting; CAPM; cost of capital; option to wait
JEL Codes: G12; G3; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| hurdle premium (G52) | CAPM-based cost of capital (G19) |
| option to defer investments (G11) | hurdle premium (G52) |
| high growth opportunities (O29) | higher cash reserves (G32) |
| higher cash reserves (G32) | higher hurdle rates (G19) |
| higher fundamental betas (C46) | higher hurdle rates (G19) |
| CAPM-based cost of capital (G19) | hurdle rates (G19) |
| option to wait (C41) | variation in hurdle rates (G19) |