Abstract
We examine how the risk-free rate (RF) and market risk premium (MRP) affect capital budgeting. While theory recommends adjusting hurdle rates for project-specific risks, many CFOs apply a single discount rate. Using graphical analysis, we show how market shifts impact investment. A decrease in RF combined with an increase in MRP – reflecting greater risk aversion – exacerbates underinvestment for firms with beta < 1 and overinvestment for those with for beta > 1 when the original WACC is applied. If only MRP increases, overinvestment intensifies. This study highlights the interplay between market variables, especially relevant for finance students and future CFOs.
Recommended Citation
(2024)
"The Effect of Risk-free Rate and Expected Market Return on Corporate Over- and Under-Investment,"
Journal of Economics and Finance Education: Vol. 23:
Iss.
1, Article 14.
Available at:
https://scholarship.rollins.edu/jefe/vol23/iss1/14
