Soumaya Keynes, FT, Friday, August 30, 2024:
In this clear and well-informed article, Soumaya Keynes discusses a very important and puzzling observation: the rigidity of the hurdle rate used by companies to determine whether or not to invest.
This is an important phenomenon for two reasons. First, it makes monetary policy less effective in stabilizing the economy, as investments appear to be less sensitive to changes in interest rates than they should be. Second, there is a form of economic inefficiency when the cost of capital used by companies diverges from the true return required by shareholders. If the hurdle rate is set too high, valuable investments are not undertaken. Conversely, if the hurdle rate is set too low, certain investments may destroy shareholder value.
Why do most companies seem so reluctant to adjust their cost of capital estimates? As Soumaya Keynes aptly noted, “something seems to be going on within the hierarchy of companies themselves.” In our view, a key reason for this reluctance is that the cost of capital is not directly observable. What managers can observe is the cost of debt. However, the cost of equity is not as transparent, since risk premia are not publicly known—they are private information. Each investor knows (or should know) the risk premium they require, but this information is not collected or aggregated. When the cost of debt falls, managers cannot be certain if this decline reflects a true decrease in the overall cost of capital or merely a shift in risk premia, with higher demand for debt and lower demand for equity. Therefore, it is unsurprising that corporate hierarchies are reluctant to open Pandora’s box and engage in complex discussions about risk premia every time the observable cost of debt changes. It is far more convenient to treat the hurdle rate as “sacred.”
It is important to note that the unobservability of risk premia has other puzzling consequences. Company managers are not the only ones using rather rigid estimates of the cost of capital. “Fundamentalist” investors also rely on cost of capital estimates as inputs for their valuation models. Generally, they are more flexible than corporate managers, as they factor in observed changes in the cost of debt. However, they too tend to use very rigid estimates for the required risk premia when it comes to the cost of equity. The reason, once again, is the lack of information about the actual risk premia required by investors. As a result, valuation models can produce inaccurate estimates, leading to potential instability in the markets. We explore this important issue further in the post “Changing Risk Premia and Asset Pricing Inefficiencies.”
It is worth noting that we are not doomed to these inefficiencies on the investment side, as Soumaya Keynes observed, or on the valuation side. Increased transparency regarding actual risk premia could significantly enhance the efficiency of financial markets, as discussed in “The Upcoming Revolution in Finance…”