We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. We find that a surprising number of firms use their firm risk rather than project risk in evaluating new investments. Firms are concerned about maintaining financial flexibility and a good credit rating when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes. Key words: capital structure, cost of capital, cost of equity, capital budgeting, discount rates, project valuation, survey. 1 We thank Franklin Allen for his detailed comments on the survey instrument and the overall project. We

this paper with an empirical investigation into some of the risk factors and demographic variables that might explain these cross-sectional differences in portfolio composition. A number of previous studies have focused on the level and variability of wage income growth as one of the largest sources of undiversifiable income risk. Here we present evidence that, for the subset of the population that has significant stock holdings, income from entrepreneurial ventures (which we refer to as proprietary business income) represents a large source of undiversifiable risk that is more highly correlated with common stock returns. These findings motivate the investigation in the second part of the paper of a linear asset pricing model that incorporates proprietary income from privately held businesses as a risk factor.

This paper studies the role of fluctuations in the aggregate consumption–wealth ratio for predicting stock returns. Using U.S. quarterly stock market data, we find that these fluctuations in the consumption–wealth ratio are strong predictors of both real stock returns and excess returns over a Treasury bill rate. We also find that this variable is a better forecaster of future returns at short and intermediate horizons than is the dividend yield, the dividend payout ratio, and several other popular forecasting variables. Why should the consumption–wealth ratio forecast asset returns? We show that a wide class of optimal models of consumer behavior imply that the log consumption–aggregate wealth ~human capital plus asset holdings! ratio summarizes expected returns on aggregate wealth, or the market portfolio. Although this ratio is not observable, we provide assumptions under which its important predictive components for future asset returns may be expressed in terms of observable variables, namely in terms of consumption, asset holdings and labor income. The framework implies that these variables are cointegrated, and

This paper explores the ability of conditional versions of the CAPM and the consumption CAPM—jointly the (C)CAPM—to explain the cross section of average stock returns. Central to our approach is the use of the log consumption–wealth ratio as a conditioning variable. We demonstrate that such conditional models perform far better than unconditional specifications and about as well as the Fama-French three-factor model on portfolios sorted by size and book-to-market characteristics. The conditional consumption CAPM can account for the difference in returns between low-book-to-market and high-bookto-market portfolios and exhibits little evidence of residual size or book-to-market effects. We are grateful to Eugene Fama and Kenneth French for graciously providing the

This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the trade-off between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and cross-sectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar-* Department of Economics, Harvard University, Cambridge, Massachusetts

As a consequence of optimal investment choices, a firm’s assets and growth options change in predictable ways. Using a dynamic model, we show that this imparts predictability to changes in a firm’s systematic risk, and its expected return. Simulations show that the model simultaneously reproduces: ~i! the time-series relation between the book-to-market ratio and asset returns; ~ii! the cross-sectional relation between book-to-market, market value, and return; ~iii! contrarian effects at short horizons; ~iv! momentum effects at longer horizons; and ~v! the inverse relation between interest rates and the market risk premium. RECENT EMPIRICAL RESEARCH IN FINANCE has focused on regularities in the cross section of expected returns that appear anomalous relative to traditional models. Stock returns are related to book-to-market, and market value. 1 Past returns have also been shown to predict relative performance, through the documented success of contrarian and momentum strategies. 2 Existing explanations for these results are that they are due to behavioral biases or risk premia for omitted state variables. 3 These competing explanations are difficult to evaluate without models that explicitly tie the characteristics of interest to risks and risk premia. For example, with respect to book-to-market, Lakonishok et al. ~1994! argue: “The point here is simple: although the returns to the B0M strategy are impressive, B0M is not a ‘clean ’ variable uniquely associated with eco-

This paper solves a realistically calibrated life-cycle model of consumption and portfolio choice with uninsurable labor income risk and borrowing constraints. Since labor income substitutes for riskless asset holdings the optimal share invested in equities is roughly decreasing over life. We compute a measure of the importance of non-tradable human capital for investment behavior to find that ignoring labor income generates large utility costs, while the cost of ignoring only its risk is an order of magnitude smaller. We also quantify the utility cost associated with typical heuristics advocated by financial advisors. The issue of portfolio choice over the life-cycle is encountered by every investor. Popular finance books (e.g. Malkiel, 1996) and financial counselors generally give the advice to shift the portfolio composition towards relatively safe assets, such as T-bills, and away from risky stocks as the investor grows older and reaches retirement. But what could be the economic

We show that corporate investment decisions can explain conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and current product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to as-sets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data. Corporate investment decisions are often evaluated in a real options context, 1 and option exercise can change the riskiness of a firm in various ways. For example, if growth opportunities are finite, the decision to invest changes the ratio of growth options to assets in place. Additionally, the resulting increase

This article presents evidence on persistence in the relative investment performance of large, institutional equity managers. Similar to existing evidence for mutual funds, we find persistent performance concentrated in the managers with poor prior-period performance measures. A conditional approach, using time-varying measures of risk and abnormal performance, is better able to detect this persistence and to predict the future performance of the funds than are traditional methods.

We show that the external habit-formation model economy of Campbell and Cochrane ~1999! can explain why the Capital Asset Pricing Model ~CAPM! and its extensions are better approximate asset pricing models than is the standard consumptionbased model. The model economy produces time-varying expected returns, tracked by the dividend--price ratio. Portfolio-based models capture some of this variation in state variables, which a state-independent function of consumption cannot capture. Therefore, though the consumption-based model and CAPM are both perfect conditional asset pricing models, the portfolio-based models are better approximate unconditional asset pricing models. THE DEVELOPMENT OF CONSUMPTION-BASED ASSET PRICING THEORY ranks as one of the major advances in financial economics during the last two decades. The classic papers of Lucas ~1978!, Breeden ~1979!, Grossman and Shiller ~1981!, and Hansen and Singleton ~1982, 1983! show how a simple relation between consumption ...