Risk and Discount Rates

In finance theory, risk plays a crucial role in capital expenditure decisions. In the standard model, the firm calculates a risk-adjusted hurdle rate and then evaluates the present value of returns from an investment project. Does risk, as measured by standard models in finance, actually influence capital expenditure decisions? I use a "revealed preference" approach to test this fundamental feature of standard finance theory, estimating the effect of risk using the Euler equation for investment. CAPM beta affects the hurdle rate. A CAPM beta above the median translates into a hurdle rate that is 600 basis points higher. The effect of high CAPM beta on the hurdle rate is highly significant. The relationship between CAPM beta and the hurdle rate is monotonic. After controlling for CAPM beta, the betas from most other cross-sectional asset pricing models (e.g., SMB, HML, momentum) have no significant effect on the hurdle rate. One exception is the Campbell-Vuolteenaho cash flow beta. The effect of the CAPM beta on discount rates is consistent with the survey evidence of Graham and Harvey (2001). But it is puzzling in light of evidence from the empirical asset pricing literature on the failure of the CAPM to explain returns. The paper examines explanations for this puzzle. Although CAPM beta has a strong effect on the hurdle rate, characteristics also affect the hurdle rate. Even after using CAPM to adjust for risk, book-to-market enters negatively and is highly significant. This is surprising, since the firm's hurdle rate should be equal to the firm's expected rate of return, and value firms tend to earn high returns. Their hurdle rate should therefore be high, not low. The paper proposes explanations for this second puzzle that are based on market "frictions."