How do Investors Compute the Discount Rate? They Use the CAPM

How do Investors Compute the Discount Rate? They Use the CAPM

By
Jonathan B. Berk, Jules H. van Binsbergen
Financial Analyst Journal. May
2017, Vol. 73, Issue 2, Pages 25-32

We provide guidance to corporate managers and investors on how to select the discount rate when evaluating investment opportunities. When making corporate investment decisions on behalf of the equity investors in a firm, an obvious choice is to use the method that equity investors use in making their own investment decisions. We infer how investors compute the discount rate by looking at mutual fund investors’ capital allocation decisions. We find that investors adjust for risk by using the beta of the capital asset pricing model (CAPM). Extensions to the CAPM perform poorly, implying that investors do not use these models to compute discount rates.