Why Do Firms Use High Discount Rates?

83 Pages Posted: 22 Mar 2014 Last revised: 30 Jun 2015

See all articles by Ravi Jagannathan

Ravi Jagannathan

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad

David A. Matsa

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)

Iwan Meier

HEC Montreal - Department of Finance

Vefa Tarhan

Loyola University of Chicago - School of Business Administration; Northwestern University - Kellogg Graduate School of Management

Date Written: June 29, 2015

Abstract

We find that operational constraints lead firms to use high discount rates that exceed their cost of financial capital, based on an original survey of CFOs with firm identifiers linked to responses. Firms with abundant access to capital but limited qualified management or manpower appear to forgo profitable projects in preparation for more profitable future investment opportunities. Consistent with this explanation, firms using high discount rates have strong balance sheets, low leverage, and large cash holdings. We conclude that operational constraints rather than financial constraints explain why firms use discount rates that are on average twice their cost of financial capital.

Keywords: Capital budgeting; discount rates; cost of capital

JEL Classification: G31; G32

Suggested Citation

Jagannathan, Ravi and Matsa, David A. and Meier, Iwan and Tarhan, Vefa, Why Do Firms Use High Discount Rates? (June 29, 2015). Available at SSRN: https://ssrn.com/abstract=2412250 or http://dx.doi.org/10.2139/ssrn.2412250

Ravi Jagannathan

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
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Evanston, IL 60208
United States
847-491-8338 (Phone)
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National Bureau of Economic Research (NBER)

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Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

David A. Matsa (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8337 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Iwan Meier

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7 H2J 2K9
Canada
(514) 340-3198 (Phone)

Vefa Tarhan

Loyola University of Chicago - School of Business Administration ( email )

820 North Michigan Avenue
Chicago, IL 60611
United States

Northwestern University - Kellogg Graduate School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

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