A
recent article indicates that financial managers may not
be following good capital budgeting techniques. The median hurdle rate used to
value new projects is 12.0 percent, with an average rate of 13.6 percent. Meanwhile,
the same survey notes that the median WACC is 9.8 percent, with a mean of 10.6
percent. While that article infers that these numbers should be the same, we
differ on this assumption. If new projects are riskier than the company, which
would likely be the case, then the cost of capital for new projects would
necessarily be greater than the WACC since the required return on a project
depends on the use of funds, not the source of funds.
Underinvestment still does occur, as 67 percent of respondents
answers “No” when asked if their company undertook all projects that create
value. Common reasons given for not pursuing value creating projects were:
Shortage of management time and expertise (51%)
The project is not consistent with the company’s core
strategy (41%)
The risk of the project is too high (39%)
Shortage of funds (38%)
Shortage of employees (32%)
