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Growth Opportunities and Investment Decisions: A New Perspective on the Cost of Capital

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  • Kee H. Chung
  • Kyu H. Kim

Abstract

This paper shows that it is not always correct to make an upward adjustment to the stock beta in calculating the hurdle rate for capital budgeting even when the project under consideration is riskier than existing assets. The paper also shows that the correct hurdle rate is smaller than the market capitalization rate calculated from the firm's stock beta when the project under consideration has the same risk as existing assets. In addition, it is shown that the market capitalization rate will be an underestimate (overestimate) of the correct hurdle rate when the risk of future assets is greater (smaller) than both the risk of assets in place and that of future capital expenditures. These new results are direct consequences of the insight that the firm's investment opportunities are in fact real call options written on underlying assets.

Suggested Citation

  • Kee H. Chung & Kyu H. Kim, 1997. "Growth Opportunities and Investment Decisions: A New Perspective on the Cost of Capital," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 24(3), pages 413-424, April.
    • Handle: RePEc:bla:jbfnac:v:24:y:1997:i:3:p:413-424
    DOI: 10.1111/1468-5957.00112
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    Cited by:

    1. Pablo De Andrés‐Alonso & Valentín Azofra‐Palenzuela & Gabriel De La Fuente‐Herrero, 2006. "The Real Options Component of Firm Market Value: The Case of the Technological Corporation," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 33(1‐2), pages 203-219, January.
    2. Kuo-Jung Lee, 2019. "The effects of social responsibility on company value: a real options perspective of Taiwan companies," Economic Research-Ekonomska Istraživanja, Taylor & Francis Journals, vol. 32(1), pages 3835-3852, January.
    3. Ian R. C. Hirst & Jo Danbolt & Eddie Jones, 2008. "Required Rates of Return for Corporate Investment Appraisal in the Presence of Growth Opportunities," European Financial Management, European Financial Management Association, vol. 14(5), pages 989-1006, November.

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