Corporate Discount Rates∗

Standard theory implies that the discount rates used by firms in investment decisions (i.e., their required returns to capital) determine investment and transmit financial shocks to the real economy. However, there exists little evidence on how firms’ discount rates change over time and affect investment. We construct a new global database based on manual entry from conference calls. We show that, on average, firms move their discount rates with the cost of capital, but the relation is far below the one-to-one mapping assumed by standard theory, with substantial heterogeneity across firms. This pattern leads to time-varying wedges between discount rates and the cost of capital. The average wedge has increased substantially over the last decades as the cost of capital has dropped. Future investment is negatively related to discount rate wedges. Moreover, the large and growing discount rate wedges can account for the puzzle of “missing investment” (relative to high asset prices) in recent decades. We find that beliefs about value creation combined with market power, as well as fluctuations in risk, explain changes in discount rate wedges over time. ∗We thank Nicholas Bloom, Olivier Dessaint, Emanuele Colonnelli, Nicolas Crouzet, Janice Eberly, Andrea Eisfeldt, Simon Gilchrist, Robin Greenwood, Samuel Hanson, Tarek Hassan, Zhiguo He, Ravi Jagannathan, Anil Kashyap, Narayana Kocherlakota, Ralph Koijen, Augustin Landier, Eben Lazarus, Christian Leuz, Erik Loualiche, Robert McDonald, Michael Minnis, Lira Mota, Brent Neiman, Ľuboš Pástor, Lasse Pedersen, Monika Piazzesi, Alp Simsek, Ludwig Straub, Douglas Skinner, Amir Sufi, Adi Sunderam, Christian Wolf, and many seminar participants for helpful comments. This research was supported by the Asness Junior Faculty Fellowship, the Becker Friedman Institute, the Fishman Faculty Research Fund, and the Fama-Miller Center at the University of Chicago. Valerii Baidin, Alexandra Bruner, Rahul Chauhan, Sean Choi, Jason Jia, Sungil Kim, Scarlett Li, Tony Ma, Daniel Marohnic, Ben Meyer, Neville Nazareth, Cagdas Okay, Prithvi Pahwa, Esfandiar Rouhani, Chris Saroza, Sixun Tang, and Madeleine Zhou provided outstanding research assistance. Both authors are at the University of Chicago, niels.gormsen@chicagobooth.edu and kilianhuber@uchicago.edu. How do asset prices and interest rates affect corporate investment? Since the early 2000s, asset prices have increased dramatically and interest rates have declined. These changes imply that financial investors have become willing to provide capital to firms in exchange for lower rates of return, which is to say that firms’ cost of capital in financial markets has decreased. The stylized view in economics is that such changes in firms’ cost of capital directly impact firm investment. According to the stylized view, firms should take on any investment project that offers returns above the cost of capital. As a result, firms should adjust their required returns on new investments (their so-called “discount rates”) one-to-one with the cost of capital in financial markets. Firms’ discount rates should, for example, have dropped substantially since the early 2000s, in line with the cost of capital, leading to a corporate investment boom (Gutiérrez and Philippon 2017). More generally, the stylized view implies that all shocks to the cost of capital, such as shocks to stock prices, monetary policy, and credit supply, directly influence firms’ discount rates and thus investment (e.g., see discussions in Gilchrist and Zakraǰsek 2012 and Koby and Wolf 2020). It is possible, however, that fluctuations in the cost of capital in financial markets are largely irrelevant to firm investment. For the stylized view to work, firms must actively choose to incorporate fluctuations in this “financial cost of capital” into their discount rates. To do so, firms need to take two steps. First, they need to estimate their financial cost of capital based on observed asset prices and interest rates. As this is a non-trivial exercise, the resulting estimate, which we term the “perceived cost of capital,” may deviate substantially from the financial cost of capital. Second, firms need to choose a required return on capital, their discount rate. The discount rate may incorporate a host of other, time-varying factors apart from the perceived cost of capital. It is thus possible that discount rates hardly comove with the financial cost of capital, so that financial prices have only modest impact on investment. Despite the conceptual importance of these discount rate dynamics, our understanding is limited because there exist little data tracing individual firms’ perceived cost of capital and discount rates over time and linking them to real outcomes. As a result, we do not know how firms adjust their perceived cost of capital over time, how discount rates change with the perceived cost of capital and other factors, and whether deviations from the stylized view Firms have substantial discretion over their discount rates (Welch 2022). For instance, firms with market power can raise their discount rates above the financial cost of capital while remaining profitable, as detailed in Section 7.