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Growth Opportunities and Investment Decisions: A New Perspective on the Cost of Capital
Author(s) -
Chung Kee H.,
Kim Kyu H.
Publication year - 1997
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/1468-5957.00112
Subject(s) - capitalization , stock (firearms) , economics , cost of capital , investment (military) , capital budgeting , business , financial economics , assets under management , investment decisions , fixed asset , finance , monetary economics , microeconomics , profit (economics) , behavioral economics , mechanical engineering , philosophy , linguistics , politics , project appraisal , political science , law , engineering , production (economics)
This paper shows that it is not always correct to make an upward adjustment to the stock beta in calculating the hurdle rate for capital budgeting even when the project under consideration is riskier than existing assets. The paper also shows that the correct hurdle rate is smaller than the market capitalization rate calculated from the firm's stock beta when the project under consideration has the same risk as existing assets. In addition, it is shown that the market capitalization rate will be an underestimate (overestimate) of the correct hurdle rate when the risk of future assets is greater (smaller) than both the risk of assets in place and that of future capital expenditures. These new results are direct consequences of the insight that the firm's investment opportunities are in fact real call options written on underlying assets.