Wednesday, 29 July 2015

Great expectations

The latest monthly business opinion survey from National Australia Bank had this interesting item.

The interesting bit, for me, was that top right hand box: the high "hurdle" rates of return that businesses typically require new investment projects to meet. There is a big puzzle here: the hurdle rates are well above the weighted average cost of capital (WACC) that finance theorists, and regulators, say should be adequate for companies to earn. The sectoral distribution of the hurdle rates makes more sense, and looks to be broadly in line with back-of-an-envelope guesstimates of the relative riskiness of the different sectors, but the levels of the hurdles looks remarkably large.

Turns out that this isn't peculiar to the sample of companies the NAB surveyed: it seems to be well nigh universal. In the latest issue of the Reserve Bank of Australia Bulletin, there's an article, 'Firms' Investment Decisions and Interest Rates', which confirms NAB's findings for Australia...

...and which also summarises international research that found exactly the same thing overseas. For example
Studies of firms overseas have found that they also use hurdle rates that are above their cost of capital. Jagannathan, Meier and Tarhan (2011) surveyed firms in the United States in 2003 and found that a typical firm used a hurdle rate several percentage points above its WACC. Brunzell, Liljeblom and Vaihekoski (2013) found a similar result for Nordic firms. Similarly, firms in other countries also appear to use hurdle rates that are not sensitive to the cost of capital
I think we can safely assume that New Zealand businesses are in the same boat (anyone aware of specific research on topic?)

We don't know exactly (or even approximately) why this happens. I've always thought that part of the explanation was a principal-agent problem: the CFO is bombarded with potential projects from ambitious executives with self-aggrandising projects, and needs some device that might help sort out the viable from the vanity (though a high hurdle rate will also have the downside of encouraging hitting fours and sixes at the expense of lower-risk steady accumulation of runs). But I'm also rather attracted to two other possible explanations canvassed in the RBA article: this one...
the level of the hurdle rate may be greater than the WACC if the potential investment has greater non-diversifiable risk than the overall operations of the firm
...and this one
managers might value the option to defer an investment until its expected net present value is greater. In the absence of more sophisticated analysis, using a hurdle rate in excess of the WACC may be a reasonable approach to account for this option value of waiting (McDonald 2000)
If I were still a regulator - and particularly a regulator looking at a sequence of projects rather than a company's overall rate of return -  I think I'd be somewhat perturbed about these results. For good reason, more enlightened regulators tend to err a little on the side of generosity when it comes to regulated WACCs, since for dynamic efficiency it is far better to slightly overcompensate than undercompensate. But when you see the prevalence of these high hurdle rates, well in excess of WACC, you wonder if there's something that the standard regulator's WACC calculation is missing.

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