Why interest rates might not drive business investments
In this paper, Gormsen and Huber construct a new global database of firms’ discount rates based on a manual entry from earnings conference calls to analyze whether low interest rates motivate firms to undertake capital investments. Standard economic theory suggests that since capital expenditure is often funded with debt, the hurdle rate, or minimum return required for new investments, should go up and down with the interest rate.
For a firm, the decision to invest follows a two-step process: First, they estimate their financial cost of capital based on observed asset prices and interest rates. The resulting estimate, which the authors term the “perceived cost of capital,” may deviate substantially from the financial cost of capital. Second, firms choose a required return, their so-called “discount rate.” Their dataset measures both discount rates and the perceived cost of capital for 2,500 firms, including many of the world’s largest corporations. The authors define as discount rate wedge as the difference between discount rates and the perceived cost of capital. They find:
- The average firm in their sample has increased its discount rate wedge by 2.5 percentage points between 2002 and 2021. The large and growing wedge suggests that firms have invested less relative to what would have been expected given the financial cost of capital. The magnitude of this effect is large;
- The drivers of discount rate wedges are risk and power: riskier firms add higher wedges to their cost of capital, and firms’ market power has limited the extent to which the secular decline in the financial cost of capital has been incorporated into discount rates.
Corporate Discount Rates
Authors: Niels Joachim Gormsen, Kilian Huber
From: University of Chicago
