Required rates of return for corporate investment appraisal in the presence of growth opportunities

Traditional methods of estimating required rates of return overstate hurdle rates in the presence of growth opportunities. We attempt to quantify this effect by developing a simple model which: (i) identifies those companies that have valuable growth opportunities; (ii) splits the value of shares into 'assets-in-place' and 'growth opportunities'; and (iii) splits the equity ß into ß for 'assets-in-place' and 'growth opportunities'. We find growth opportunities for UK companies over the 1990-2004 period to average 33% of equity value. Incorporating the effect of growth opportunities, the average cost of capital for investment purposes falls by 1.1 percentage points. © 2008 Blackwell Publishing Ltd.