Does Corporate Investment Respond to the Time-Varying Cost of Capital? Empirical Evidence
Published in Journal of Financial and Quantitative Analysis, August 2020
Companies typically grow business through a series of investments -- for instance, opening a new store or expanding a production line. Along the way, they face critical decisions as to whether to go ahead with a certain investment opportunity. Common sense tells that companies should invest only when benefits from investment outweigh costs. In this decision, the discount rate plays a crucial role; it helps to fairly compare the costs and benefits, which tend to occur in different points in time.
Despite its importance, determining the discount rate has been elusive in practice. History in financial markets implies that the discount rate fluctuates across time, but conventional approaches to estimating the rate do not successfully detect these fluctuations. As a result, these discount-rate estimates often appear irrelevant to corporate investment, allowing some researchers to assert an irrationality in corporate decisions.
This paper revisits the long-standing question of whether companies invest rationally, but with an alternative identification of the discount rate. In particular, Dr Yongjin Kim of the Department of Economics and Finance uses option prices and recovers return-relevant information from the prices observed in a snapshot of time.
“Relying just on real-time prices, this new measure accurately captures shifts in the discount rate, in contrast to the conventional measures,” says Kim.
“Next, employing this option-based measure, I establish that a change in discount rate strongly predicts firm investment. Furthermore, I find that an even stronger prediction of theory holds empirically; investment is almost equally sensitive to the discount rate and future cash flows.”
In short, the findings suggest that corporate investment indeed responds rationally to discount rate. This evidence can serve as a basis for a government policy to stimulate investment through adjusting the interest rates.