In Practice Using A Higher Hurdle Rate

Some firms choose what seems to be a more convenient way of selecting projects, when they face capital rationing — they raise the hurdle rate to reflect the severity of the constraint. If the definition of capital rationing is that a firm cannot take all the positive net present value projects it faces, raising the hurdle rate sufficiently will ensure that the problem is resolved or at least is hidden. For instance, assume that a firm has a true cost of capital of 12%,5 a capital rationing constraint of $100 million, and positive net present value projects requiring an initial investment of $250 million. At a higher cost of capital, fewer projects will have positive net present values. At some cost of capital, say 18%, the

5 By true cost of capital, we mean a cost of capital that reflects the riskiness of the firm and its financing mix.

positive net present value projects remaining will require an initial investment of $100 million or less.

There are problems which may result from building the capital rationing constraint into the cost of capital. First, once the adjustment has been made, the firm may fail to correct it for shifts in the severity of the constraint. Thus, a small firm may adjust its cost of capital from 12% to 18% to reflect a severe capital rationing constraint. As the firm gets larger, the constraint will generally become less restrictive, but the firm may not decrease its cost of capital accordingly. Second, increasing the discount rate will yield net present values that do not convey the same information as those computed using the correct discount rates. The net present value of a project, estimated using the right discount rate, is the value added to the firm by investing in that project; the adjusted present value estimated using an adjusted discount rate cannot be read the same way. Finally, adjusting the discount rate penalizes all projects equally, whether they are capital intensive or not.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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