Anton, Arun V (2019) Choice of discount rate and agency cost minimisation in capital budgeting: analytical review and modelling approaches. Other Degree thesis, Victoria University.

Abstract

Capital budgeting is a crucial business function and most large firms use Discounted Cash Flow (DCF) methods, particularly the Net Present Value (NPV) method which takes into account the time value of money, for evaluating investment projects. Hence, the discount rate plays a major role in the choice of capital investments, and both the selection and appropriate use of a suitable discount rate are critical to sound capital budgeting. Extensive evidence from the literature indicates that agency problems exist in capital budgeting decisions, both when choosing and when using a discount rate for this process. Managers as agents can manipulate the choice of the discount rate to maximise their own benefits. This creates an agency problem that has impacts on efficient capital investment decisions. Most firms believe that using project-specific discount rates may open up incentives for managerial opportunistic behaviour and hence they prefer firm-wide single discount rates that might moderate the managerial bias. In other words, most firms use their company-wide Weighted Average Cost of Capital (WACC) to evaluate all of their capital projects. However, company-wide WACC is not a correct approach, in that it may lead to the selection of high-risk, unprofitable projects and hence to inefficient allocation of resources. This creates a need for a systematic and verifiable method to establish project- specific discount rates. If possible, the determination of these project-specific discount rates should be tied to outside market forces that are not under the control of the manager. But the selection of suitable project-specific discount rates alone may not completely minimise agency costs, as managers’ can manipulate capital budgeting decisions to maximise their benefits. Hence, an appropriate capital budgeting framework that can further minimise agency costs and maximise company value is required. The main aims of the study are to develop a process to select appropriate project- specific discount rates that minimise agency costs and to develop a better capital budgeting framework to further minimise agency costs in capital budgeting. Such a framework should provide management incentives to achieve efficient capital budgeting outcomes leading to enhanced company value

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