As upbeat as CFOs may feel about the growth prospects for their own companies and the broader economy, they have yet to loosen the criteria they use for making investment decisions.
In the second-quarter Duke University/CFO Magazine Global Business Outlook Survey, which collected responses from 750 senior finance executives, respondents revealed that they have maintained unusually high — even unrealistic — hurdle rates, or the minimum return they expect from any project they opt to invest in.
While expectations for U.S. earnings growth, technology spending, and revenue have declined slightly since the previous quarter — the most significant decrease being revenue projections, from 8.1% to 6.2% — expectations for capital spending increases have declined, from 5.8% to 2.2%. Among prospective strategic investments, presumably, few offered enough potential to clear existing hurdle rates.
According to the survey, the median hurdle rate U.S. companies use to evaluate investment projects is 12.0, while the mean is 13.6. Companies typically review and revise their hurdle rate to keep it below what it costs them to borrow money, hoping to ensure a robust return. The cost of capital, however, first began falling in the wake of the 2008 financial crisis, when the Federal Reserve pushed interest rates to zero, and has only recently begun to edge up ever so slightly. Hurdle rates, apparently, haven’t lost altitude, which may mean that an abundance of corporate investments can’t be cleared for takeoff.
Among survey takers, the median weighted average cost of capital (WACC) stands at 9.8, with the mean at 10.6, indicating that finance executives have been reluctant to lower their hurdles to suit the changed environment. (Companies often use the WACC as their hurdle rate, raising it for riskier projects.) Assuming CFOs are not distracted drivers — of business growth — they may be routinely passing up value-enhancing opportunities.
Whatever the reason, it’s not because they feel especially anxious about the U.S. economy’s overall prospects. The Duke/CFO optimism index for the U.S. is at 67 on a 100-point scale, far above the long-run average of 60. As of the second quarter, U.S. respondents expect earnings growth of 8.2% during the forthcoming 12 months, a marginal move downward from the 8.6% they projected in the first quarter. Growth in hiring, projected at 1.7% a year ago, has risen steadily since the last quarter of 2016, with respondents now anticipating a 12-month increase of 3.8%.
The consequences of relying on a poorly conceived hurdle rate aren’t just that the company will miss out on some winning bets. The misallocation of capital ultimately creates inefficiencies. Investing in less-than-suitable projects, for instance, mars productivity.
Of course, it could be that finance executives haven’t tinkered with their hurdle rates because they assume that interest rates might skyrocket at any time. The low cost of capital, they may be reasoning, is both artificial and temporary. Feasting on cheap money could leave companies overstuffed when interest rates climb, saddling them with investments that they can no longer support.
But the abnormally low-rate environment has lingered for several years. Granted, interest rates have begun creeping upward, thanks to action by the Federal Reserve. That said, given the anemic inflation rate of under 2%, the central bank may slow the pace and number of rate hikes for the rest of 2017 and 2018. The survey finds that U.S. companies have tapered their expectations for raising their own prices over the next 12 months, from 3.0% last quarter to 2.5% in this survey.
Higher hurdle rates, and the under-investment that results from them, typically reflect management’s level of uncertainty about the future. Since they are usually used to assess longer-term strategic investments, the return on such projects is measured against assumptions about what the cost of capital will be over the entire life of the project. Senior finance managers may be funneling their own qualms into their hurdle rates, fearing that the cost of capital will increase in the medium to long term. Or they may have reason to doubt the accuracy of their own forecasting process.
As the global economy struggles to find a secure economic footing, finance executives may be justified in hesitating when it comes to evaluating a project or investment’s viability in the context of future economic conditions. In the survey, more than one-third of respondents (36%) say that their companies face a higher-than-normal level of uncertainty. Nearly 60% of those respondents say that uncertainty will lead their companies to grow at a slower pace or to delay expansion plans.
As part of the survey, senior finance executives were asked to select the reason that prevents their companies from pursuing projects that they have calculated as capable of creating value. The most common answer, chosen by about half (51%) of finance executives, is “shortage of management time and expertise,” a broad catch-all that covers a multitude of reasons, from lack of confidence in assessing risk in new markets to a shortage of the skills necessary to turn an investment into a product. By comparison, for example, African finance executives attribute their limited ability to pursue value-creating projects to a more concrete obstacle: shortage of funding.
The United States is the only region to rank the “shortage of management time and expertise” explanation so high, says John Graham, professor of finance at Duke University. “This suggests that U.S. managers are working full-tilt, or that there is a tight labor supply in terms of skilled managers,” or both, he says.
The other choices that sizable numbers of U.S. respondents select include “project is not consistent with company’s core strategy” (41%) and “the risk of the project is too high” (39%). Almost 38% cite a shortage of funding and almost 32% a shortage of employees. Some respondents offer more-specific reasons: “activism’s influence on capital allocation,” the “general conservative nature of executive management,” too many years “to recover investment,” and “ever-changing consumer demand and government regulations.”
But the reasons given don’t fully explain why so many senior finance executives seem to disregard hurdle rates when making high-stakes strategic investment decisions. In the survey, a massive 67% of respondents answer “no” when asked if their company pursues all projects that are expected to earn a return higher than the hurdle rate. Only about one-fifth of respondents reply in the affirmative.
It may be that the hurdle rate itself is the problem. Senior finance executives face dangers when relying on a hurdle rate that hasn’t kept pace with the fast-moving economy. As the survey finds, it’s far too easy to come up with a hurdle rate that is well worth ignoring.