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:
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 ...