The “hurdle rates” of return that U.S. companies use to decide whether to invest in a project have remained stubbornly high, even as the cost of capital has fallen significantly, according to results from the second quarter Duke University/CFO Global Business Outlook Survey.
The median hurdle rate U.S. companies use to evaluate investment projects is 12, based on the 306 finance executives responding to the survey; the mean 13.6. Respondents’ median weighted average cost of capital (WACC) is 9.80, with the mean 10.6.
Modern finance theory says that as long as an investment earns a rate higher than the cost of capital, it creates value for a firm. Thus, when the hurdle rate exceeds the cost of capital, a firm is passing up value-creating projects, explains John Graham, professor of finance at Duke University.
Given how the average hurdle rate has remained high while the cost of capital has fallen, this ‘problem’ of passing up value-creating projects has gotten bigger in recent decades, says Graham, referencing data that goes back to the 1980s. “Our [recent] survey confirms that the general relation still holds,” he says.
Finance chiefs of U.S. companies have plenty of reasons, though, for using hurdle rates higher than their cost of capital.
“WACC is fairly known, but investments have many forms of risk. An excessive premium is needed given the fundamental flaws in the calculations,” says a manufacturing CFO whose company uses a hurdle rate of 11%.
Says another CFO: “We add an approximate 200-basis-point spread to growth projects to account for incremental project risk and execution risk.” Added a finance executive from the banking industry: “Our hurdle rate is equal to our cost of equity, which ensures we keep our eye towards making a good return to our shareholders.”
So what do U.S. companies do when a project’s forecast rate of return is higher than the hurdle rate they use? Even in those cases, companies are passing on growth investments.
When asked if their company pursues all projects that are expected to earn a return higher than the hurdle rate, only 20.6% of finance executives responding to the Duke/CFO survey say “yes.” About two thirds (67.2%) of them say “no.”
What’s preventing companies from pursuing these value-creating projects? “Shortage of management time and expertise” was the most popular answer, given by 50.9% of finance executives, followed by “project is not consistent with company’s core strategy” (41.4%) and “the risk of the project is too high” (38.8%).
Almost 38% cite a shortage of funding and 31.9% a shortage of employees.
The United States is the only region to rank the “shortage of management time and expertise” explanation so high, says Graham. “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. “I find that quite interesting,” he adds.
Other factors that are causing U.S. finance executives to be highly selective with growth investments include “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.”
In some parts of the world, according to the Duke/CFO survey, companies are saying “yes” to a greater percentage of projects that have a projected return higher than their hurdle rate.
In Europe, for example, 43% of finance executives said they puruse all projects that they expect to earn a return higher than their hurdle rate. But CFOs in Latin America and Asia are choosier: 31% of Latin Amerrican finance chiefs green-light all projects with returns higher than the hurdle rate, and only 19% of finance chiefs at Asian companies say they do the same.