Does Corporate Investment Respond to the Time-Varying Cost of Capital? Empirical Evidence

Abstract

I examine whether the time-varying cost of capital is considered in firms' capital budgeting decisions. For this test, I measure the conditional cost of equity using individual equity option prices. I find that corporate investment responds negatively to fluctuations in the option-implied cost of equity and the weighted average costs of capital. Furthermore, through decomposing marginal, I reveal that the cost-of-capital elasticity of empirical investment is almost identical to its productivity elasticity, as theory predicts. These findings suggest that firms' discount rates are updated accurately in practice despite the failure of conventional frameworks, such as factor-based models, in this regard.