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 idiosyncratic risk.

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.

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.

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 accurate.

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.