Strategic Corporate Finance: Applications in Valuation and Capital Structure

WACC AND HURDLE RATES

Many companies use a higher required return for investments than their actual cost of capital, often with artificial decrees to compensate for poor sensitivity or risk analysis, free capital and with an excessive reliance on single-point estimates of an internal rate of return (IRR) or NPV. In many companies, capital is “free” because once investment approval is negotiated, it is a sunk cost to managers. Thus, in most cases, capital must be rationed precisely because it is free. Alternatively, when capital bears its own true cost, it becomes plentiful but expensive. But hurdle rates destroy value:

• Starve growth by systematically obstructing value-adding investment opportunities
• Lead to inflated projections by the proponents of investment opportunities
• Steer the company away from beneficial activities of more comprehensive risk analysis and creative risk management
• Reduce the company’s weighted average return on capital by forfeiting positive NPV investment opportunities

To offset the problems of poor risk analysis and free capital, hurdle rates that exceed the cost of capital are frequently imposed on managers. This attempt to subsume a proper risk analysis and compensate for overly optimistic forecasts typically leads to more optimistic forecasts. The practical corollary to the deceptively simple allure of inflated hurdle rates is a reduced emphasis on even simple risk analysis and more optimistic forecasts.

Increasing a project’s rate of return does not ...