Working Papers
Capital Budgeting and Idiosyncratic Risk
[SSRN Version]
- Best paper at the 2019 FRA Conference in Las Vegas
- Best Ph.D. paper at the 2019 FRA Conference in Las Vegas
- Cubist Systematic Strategies Ph.D. Candidate Award at the 2019 WFA Conference in San Francisco
This figure contrasts the projects' production forecast rate of decline with the realized production rate of decline of the median gas well, and the 10th and 90th percentile.
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Using an NPV-based revealed-preference strategy, I find that idiosyncratic risk materially affects the discount rate that firms use in their capital budgeting decisions. I exploit quasi-exogenous within-region variation in project-specific idiosyncratic risk and find that, on average, firms inflate their discount rate by 5 percentage points (pp) in response to an 18 pp increase in idiosyncratic risk. Moreover, these discount rate adjustments are negatively associated with various measures of firm profitability. I then explore how proxies for costly external financing and agency frictions relate to discount rate adjustments. I find that firms appear to adjust their discount rate upward as a form of risk management when facing costly external financing frictions. Also, I provide evidence that firms partially insure managers against project-specific underperformance to mitigate discount rate adjustments due to agency frictions. |
Discount Rate Uncertainty and Capital Investment (November 2020), with Hendrik Bessembinder
[SSRN Version]
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Firms obtain noisy estimates of investors’ required rates of return (discount rates) using market-based information. Discounted-cash-flow (DCF) methods as commonly taught in MBA courses lead to upward-biased estimates of project values in the presence of such noise, even when cash flow and discount rate estimates are unbiased, due to Jensen’s inequality. We show that this bias affects corporate investment decisions and firm financial performance, and we test additional predictions derived from the DCF model in the presence of noisy discount rates. Our evidence implies that a one standard-deviation increase in discount rate uncertainty is associated with increased firm investment of 8%, while profitability decreases by 4%.
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Articles Published in Refereed Journals
Real Option Exercise: Empirical Evidence, with Erik P. Gilje and Jérôme P. Taillard ( Review of Financial Studies )
[SSRN Version] [RFS Version]
- Best paper at the 15th Annual Conference in Financial Economics at IDC-Herzliya (2018)
- Best paper at the 6th Annual USC Marshall Ph.D. Conference in Finance (2018)
This figure plots the distribution of the estimated forgone value, the difference between the underlying value (V) and the real option trigger value (V*) (i.e., V-V*) . A value to the left of the vertical line at zero corresponds to exercising the real option too early.
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We study when and why firms exercise real options. Using detailed project-level investment data, we find that the likelihood that a firm exercises a real option is strongly related to peer exercise behavior. Peer exercise decisions are as important in explaining exercise behavior as variables commonly associated with standard real option theories, such as volatility. We identify peer effects using localized exogenous variation in peer project exercise decisions and find evidence consistent with information externalities being important for exercise behavior.
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