hurdle rate, the rate of return that managers expect a new project to earn before they are willing to undertake it. Hurdle rates vary across firms and types of projects and they are set by managers, not capital markets. This distinguishes the hurdle rate from the cost of capital, the rate of return before corporate taxes that the firm must earn on new investments to provide shareholders and bondholders with the returns they demand. The cost of capital is sometimes confused with one of its components, the cost of funds, which indicates the rate of return that financial investors demand on their investment income before taxes. The cost of funds depends on the required returns in the markets for both debt and equity. The cost of capital is the pre-tax return that a company must earn to deliver the cost of funds to investors. It therefore depends on the tax rules governing corporations as well as on the cost of funds. 7 A firm’s hurdle rate includes the cost of capital and also an internal risk premium considered applicable by management to the particular project at that particular time.8

Although differences in the cost of capital and the cost of funds across firms and nations have been the subject of numerous studies of investment spending, they may provide an incomplete explanation of what determines investment. Because financial investors cannot always ensure that managers follow their wishes, the hurdle rate may differ from the cost of capital. If managers set hurdle rates above the cost of capital, they are being more selective than their financial investors would like them to be, turning down some projects that might have earned returns that would fully satisfy their financiers. If the hurdle rate is below the cost of capital, managers are undertaking too many or too risky projects. Under these conditions, financial investors may try to change the managers’ hurdle rate or in extreme cases replace the management team.

The relationship among these concepts can be illustrated by means of a simple figure (Figure 3). Interest rates or costs of funds are set by the balancing of the supply and demand of funds in the financial markets (level A) and is where the saving rate has its effect. At level B, the tax system determines what return the corporation must achieve to satisfy the financial investors’ cost of funds requirements. At level C, other factors can cause management to elevate or reduce the return they want from

7

Other components of the tax system, such as the tax treatment of individuals and other investors, affect the cost of capital by changing investors’ before-tax required returns, hence the cost of funds.

8

See R. Landau, “From Analysis to Action.”



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