Such operational considerations as managerial or organizational requirements—not
financial constraints—are the primary drivers of capital rationing among public
corporations, which leads firms to systematically evaluate their projects using discount
rates that exceed their cost of financial capital. This finding explains why firms use, on
average, twice their cost of financial capital in evaluating projects.
The authors explain why firms forgo apparently profitable investment opportunities. They
note that using higher discount rates may be interpreted as a form of capital rationing when
limitations prevent a company from undertaking all projects with a positive net present
value (NPV). Indeed, firms use discount rates that are, on average, about twice their cost
of financial capital, but there is significant variation in these numbers across firms.
The authors find that although most firms use the weighted average cost of capital (WACC)
as the basis for their discount rates, they usually augment it before using it to evaluate
projects. The firms that add the largest premiums are exposed to high levels of
Contrary to the traditional view that financially constrained firms must ration their
available capital and thus forgo profitable opportunities, the authors find that the firms
that add the largest premiums to their cost of financial capital generally have large cash
holdings. These firms are thus not financially constrained, leading the authors to conclude
that the firms are hoarding cash in anticipation of more valuable projects. In addition,
these firms may also have such operational constraints as limited time to expand their work
force and limited managerial bandwidth. The authors find that in such circumstances, firms
inflate their discount rates above their cost of financial capital to account for such
constraints or expectations. In contrast, financially constrained firms tend to have
discount rates closer to their cost of financial capital.
How Is This Research Useful to Practitioners?
For principal investors who review businesses, the authors’ findings should enhance
the way they assess the internal hurdle rates used by potential investee companies.
The authors’ findings are useful to professionals involved in the capital-budgeting
process because they provide a clearer framework for assessing the appropriateness of the
premium added to a firm’s estimated cost of financial capital. Although the
authors’ conclusions may not change an existing capital-budgeting process, their
findings can provide a richer framework for the qualitative assessment of projects—an
assessment that takes into account identified operational constraints and reflects how those
constraints affect the hurdle rate.
How Did the Authors Conduct This Research?
Because information on discount rates used by firms is not observable, the authors design a
survey that captures this information directly from a list of 127 sample firms. As an
accuracy check, the survey asks for such observable data as reported sales. These
self-reported but observable data match data retrieved from Compustat for 97% of the
responses, leading the authors to conclude that the disclosures on discount rates seem
The authors report that 97% of the sample firms use a discounted cash flow method as one of
their top two capital-budgeting methods. The mean of the reported discount rates is 15.1%
(with a median of 15.0%) in nominal terms. Some 74.4% of the analytic sample responded that
their reported discount rates represent their WACC. In order to relate the sample
firms’ discount rates to their cost of financial capital, the authors combine the
survey answers with data from Compustat, CRSP, and Barra.
Using the survey responses and publicly available data, the authors model linear
regressions to assess a number of relationships between the self-reported discount rates and
the cost of financial capital as well as variables that measure the impact of financial
constraints, operational constraints, managerial biases, and idiosyncratic risk.
The authors make a strong case for operational constraints as a determinant of decisions
regarding the capital-budgeting process. The authors design a survey that yields information
that can be mined for additional information to explore their arguments and conclusions.
Their work provides a good basis for examining the nature of the organizational constraints
that are most relevant to the capital-budgeting process. Moreover, the assessment of the
importance of operational constraints to the capital-budgeting process can be refined by
identifying more stringently what constitutes key operational constraints.