Capital Budgeting and Idiosyncratic Risk
80 Pages Posted: 17 Nov 2019 Last revised: 21 Jan 2024
Date Written: January 19, 2024
Abstract
Using a NPV-based revealed-preference strategy, I find that managers increase the discount rate used in capital budgeting decisions upward to account for idiosyncratic risk. To establish causality, I exploit quasi-exogenous within-region variation in project-specific idiosyncratic risk. I then decompose the measure of idiosyncratic risk into a good and a bad component and show that discount rate adjustments appear to penalize exposure to downside risk. Finally, I explore how costly external financing, internal monitoring frictions, and CEOs' personal exposure to idiosyncratic risk affect those adjustments. Overall, financial and operational frictions induce managers to account for idiosyncratic risk when computing discount rates.
Keywords: Capital Budgeting, Discount rate, Idiosyncratic Risk, Corporate Investment, Risk Management, Governance
JEL Classification: G30, G31, G32
Suggested Citation: Suggested Citation