Capital Budgeting and Idiosyncratic Risk

Abstract

Using an NPV-based revealed-preference strategy, I find that idiosyncratic risk materially affects the discount rate that firms use in their capital budgeting decisions. I exploit quasi-exogenous within-region variation in project-specific idiosyncratic risk and find that, on average, firms inflate their discount rate by 5 percentage points (pp) in response to an 18 pp increase in idiosyncratic risk. Moreover, these discount rate adjustments are negatively associated with various measures of firm profitability. I then explore how proxies for costly external financing and agency frictions relate to discount rate adjustments. I find that firms appear to adjust their discount rate upward as a form of risk management when facing costly external financing frictions. Also, I provide evidence that firms partially insure managers against project-specific underperformance to mitigate discount rate adjustments due to agency frictions.