Let us first consider the “short-horizon” case, in which the goal is to maxi-
mize the current stock price. It is easy to see that in this case, the “value” cre-
ated by investing is simply (P−1). Intuitively, as long as the market’s current
valuation of the assets in question exceeds the acquisition cost, the current
stock price will be increased if the assets are purchased. To translate this into
a statement about hurdle rates, note that, from management’s perspective,
the expected cash flow on the investment is Fr. Thus the short-horizon hurdle
rate, defined ashS, has the property that the gross discounted value of the in-
vestment, Fr/(1+hS), equals P. Using Eq. (10), it follows immediately that
Proposition 1.In the short-horizon case, the manager should discount
his expected cash flow Frat a hurdle rate hS=CER. In other words,
the manager should take a NEER approach and use the conditional
expected return on the stock as the hurdle rate.One way to think about Proposition 1 is that, if the manager is interested
in maximizing the current stock price, he must cater to any misperceptions
that investors have. Thus if investors are overly optimistic about the
prospects for the firm’s assets—thereby leading to a low value of CER—the
manager should be willing to invest very aggressively in these assets and
hence should adopt a low hurdle rate.
Things work quite differently in the “long-horizon” case, in which the
manager seeks to maximize his perception of the present value of future
cash flows. In this case, the “value” created by investment is (P−1). That
is, the manager should only invest if the rational expectations valueof the
assets exceed their acquisition cost. Thus the long-horizon hurdle rate hL
has the property that Fr/(1+hL)=P. Using Eq. (8), this leads to
Proposition 2.In the long-horizon case, the manager should discount
his expected cash flow Frat a hurdle rate hL=k*. In other words,
the manager should take a FAR approach and choose a hurdle rate
that reflects the fundamental risk of the assets in question and that is
independent of outside investors’ bias δ.Proposition 2 suggests that hurdle rates in the long-horizon case should be
set in a “CAPM-like” fashion. This is very close in spirit to the standard text-
book prescription. However, the one major caveat is that, unlike in the text-
book world, one needs to be more careful in the empirical implementation.
According to Eq. (6) and (7), the β* that is needed for this CAPM-like calcu-
lation is the (unobserved) βthat would prevail in a rational expectations
world, as this is the correct measure of the fundamental risk borne by
long-horizon investors. And given that the underlying premise throughout
is that the stock market is inefficient, one cannot blithely make the usual
assumption that a βcalculated in the traditional way—with a regression of
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