Date Added: Feb 2011
Whereas Poterba and Summers (1995) find that firms use hurdle rates that are unrelated to their CAPM betas, Graham and Harvey (2001) find that 74% of their survey firms use the CAPM for capital budgeting. The authors provide an explanation for these two apparently contradictory conclusions. They find that firms behave as though they add a hurdle premium to their CAPM based cost of capital. Following McDonald and Siegel (1986), they argue that the hurdle premium depends on the value of the option to defer investments. While CAPM explains only 10% of the cross-sectional variation in hurdle rates across firms, variables that proxy for the benefits from the option to wait for potentially better investment opportunities explain 35%.