Growth opportunities and investment decisions: A new perspective on the cost of capital

This study finds that conventional wisdom on risk-adjusted hurdle rates for firms' investment decisions will not be a reliable guide once we recognize the options feature of firm's growth opportunities. Managers are advised in finance textbooks that the market capitalization rate calculated from the firm's stock beta may be used for capital budgeting analysis as long as the firm remains in the same business-risk class. They are also advised that an upward adjustment must be made to the market capitalization rate when the project under consideration is riskier than existing assets. In this study, it is shown that these guidelines suggested by the traditional capital budgeting analysis are erroneous once we view the firm's growth opportunities as real call options. The results of our analysis suggest the following managerial implications for firms' investment decisions: (i) managers should make a downward adjustment to the market capitalization rate calculated from the stock beta to obtain the correct hurdle rate for capital budgeting when the asset under consideration has the same risk as existing assets; (11) even when managers feel that the project under consideration is riskier than existing assets, they should not always make an upward adjustment to the stock beta in calculating the hurdle rate; and (111) when future capital expenditures as well as the value of future assets are stochastic, managers should make an upward (downward) adjustment to the market capitalization rate calculated from the stock beta if the risk of future assets is greater (smaller) than both the risk of existing assets and that of future capital expenditures. In the real world environment managers are unlikely to have all the information necessary for the calculation of the exact hurdle rate. It would be fair to say, however, that the results of this study provide at least some indication regarding the direction of adjustments managers should make on market capitalization rates given their judgment on the relative risk of proposed project as compared to that of existing assets and future capital expenditures.