Corporate Investment Decision Practices and the Hurdle Rate Premium Puzzle

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Corporate Investment Decision Practices And the Hurdle Rate Premium Puzzle
Iwan Meier and Vefa Tarhan1

February 27, 2006

Abstract

We survey a cross-section of 127 companies to shed light on various dimensions of the investment decisions. The questions posed by our survey examine the hurdle rates firms use, calculations of project related cashflows, the interaction of cashflows and hurdle rates, and the determinants of firms’ capital structure policies. Unlike previous studies which examine investment decisions by either using survey data or data obtained from financial tapes, we use both sets of data. This approach produced one of our primary findings that there is a hurdle rate premium puzzle, in that hurdle rates used by our sample of firms exceed their cost of capital that we calculate using Compustat data by 5%. We investigate the determinants of the hurdle premium in question. Additionally, we find that both systematic and to a lesser extent unsystematic risk play a role in determining the hurdle rates. Furthermore, our findings show that while firms use discounted cashflow methods in evaluating projects, they do not always appear to handle the cashflow dimension of their investment decisions in a consistent manner. Finally, we uncover evidence that firms use the various financing alternatives available to them in the order predicted by the pecking-order hypothesis. However, some of the variables affiliated with the trade-off model also appear to play a role in the capital structure decision.

JEL classification: G31; G32 Keywords: Capital budgeting; Cost of capital; Discount rates; Capital structure; Survey

HEC Montréal, and Loyola University, Chicago. Corresponding author: Iwan Meier, HEC Montréal, 3000 chemin de la Côte-Sainte-Catherine, Montréal (Québec) H3T 2A7, Canada. Tel. +1-514-340-3198; e-mail address: iwan.meier@hec.ca. We thank Deborah…...

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