Growthopportunities and Investment Decisions: a New Perspective Onthe Cost of Capital

Recently studies have suggested that growth opportunities possessed by a firm can be regarded as real options and applied contingent-claims analysis to evaluate them in conjunction with the firm's operating environment (see Stulz, 1982; Baldwin, Mason and Ruback, 1983; Kester, 1984 and 1986; Brennan and Schwartz, 1985; Mason and Merton, 1985; Majd and Pindyck, 1987; Pindyck, 1988; and Chung and Charoenwong, 1991; among others). Empirical results suggest that a significant portion of themarket value of firms is accounted for by growth opportunities. For instance, Kester (1984 and 1986) finds that the value of growth opportunities frequently accounts for more than 50 percent of the market value of firms. Furthermore, Kester finds that the fraction is about 70 to 80 percent in industries with high demand volatility. More recently, Pindyck (1988) argues that the fraction of market value attributable to future growth options may be one-half or more for firms with reasonable demand volatility. Although these studies have provided a significant insight into the nature of growth opportunities and their relative importance as a component of corporate value, none of these studies has examined the implications of an options interpretation of growth opportunities for the firm's cost of capital and investment decisions. The purpose of this paper is to closely examine the implications of this new insight (i.e., the options interpretation of growth opportunities) for the hurdle rate for the firm's capital budgeting analysis. Conventional financial theory has suggested that one should make an upward adjustment to the stock beta in calculating the hurdle rate for capital budgeting when the project under consideration is riskier than existing assets. Theory also advises managers to use capitalization rates calculated from stock betas as long as the riskiness of projects is the same as that of existing assets. The results of our analysis suggest, however, that these traditional Journal of Business Finance&Accounting, 24(3) & (4), April 1997, 0306-686X