Do asset prices and interest rates significantly influence investment? They should, according to economic theory. Since the early 2000s, asset prices have risen sharply and interest rates have fallen, indicating that financial investors are now willing to provide capital at lower returns, thus reducing firms’ cost of capital. The standard economic view is that such reductions in the cost of capital should lead to increased investment by firms, as they should pursue projects with returns higher than their cost of capital, adjusting their discount rates: A discount rate for firms is the minimum return a company wants to earn on an investment to make it worthwhile (also known as “hurdle rate”), considering the risk associated with the project and the time value of money. A related term is the weighted average cost of capital (WACC), which is the return expected by financial investors in return for providing capital to the firm. In standard economic models, the discount rate and the cost of capital are equal. In practice, they differ strongly, as this research has shown. (or hurdle rates) accordingly. This implies that firm investments should have surged as discount rates fell, driven by lower capital costs.
However, it is possible that firms do not necessarily align their discount rates with changes in the financial cost of capital. To do so, firms would need to estimate their perceived cost of capital and adjust their required return on capital accordingly, which—it turns out—does not happen consistently. Likewise, fluctuations in financial costs might have only a limited impact on firm investment, at least over certain periods of time. Why is this so?
To address this question, the authors examine the relationship between corporate discount rates, investment, and the cost of capital by constructing a new firm-level database consisting of firms’ discount rates and perceived cost of capital, matched to investment rates. These data were gathered from 74,000 paragraphs in corporate conference calls between 2002 and 2021, where managers discussed discount rates and perceived cost of capital. The authors’ analysis covers approximately 2,500 large firms across 20 countries.
Using their novel database, the authors interrogate the traditional economic view that firms immediately integrate cost of capital shocks into their discount rates using newly constructed data. They find the following:
- While firms’ perceived cost of capital reflects financial cost variations, significant deviations and heterogeneity exist. Firms often report discount rates higher than their perceived cost of capital.
- In the short and medium term (up to 4 years), changes in perceived cost of capital have minimal impact on discount rates, which rarely change within these periods. This phenomenon results in “discount rate wedges,” or the difference between discount rates and the perceived cost of capital, that vary over time and are negatively related to firm investment.
- Only over the long term (more than 10 years) do discount rates align with the perceived cost of capital, challenging the idea that cost-of-capital shocks directly affect investment.
- Discount rate wedges have increased by approximately 2.5 percentage points between 2002 and 2021, especially after 2010, when perceived costs fell but discount rates did not follow suit.
- These persistent wedges impact investment. For example, a 1 percentage point increase in the wedge correlates with a 0.9 percentage point decrease in investment rates over the following year.
- Firms with higher discount rates also report higher realized returns, supporting the idea that discount rates reflect required returns and influence investment behavior.
Bottom line: The existence of discount rate wedges indicates that changes in the cost of capital do not straightforwardly impact investment in the short and medium term, challenging traditional models of the investment-finance relationship. What, then, explains this behavior? The authors suggest that managers on conference calls may be ensuring prudence in their investment decisions by keeping discount rates stable, especially when the cost of capital is falling. The benefit of conservative financial behavior seems to outweigh the cost of investing less, at least in the eyes of managers. Further, the authors’ data indicate that firms with high market power in 2002 were largely responsible for the secular increase in wedges, suggesting that weak competition makes it less costly for firms to introduce high discount rate wedges.