APPLIED FINANCE CENTRE
Faculty of Business and Economics
Hurdle Rates, Cost of Capital & Capital Structure:
CFO Spotlight
Tony CarltonApplied Finance CentreMacquarie University
FTA Congress30th October, 2015
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Outline
Capital allocation hurdle rates & WACC
Financial Risk Management & Capital Structure
Risk Metrics for Non-financial companies
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Hurdle rates & WACC
WACC = Equity Cost x (1 Target Debt Ratio)+ Debt Cost x (1 Tax Rate) x Target Debt Ratio
Weighted Average Cost of Capital blends costs of finance for project, based on project characteristics
Equity Cost = Risk Free Rate + Beta x Market Risk Premium
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Hurdle rates & WACC
Variation in application of WACC parameters lead to variation of +/ - 1.5%
Component Best Practice Actual PracticeRisk Free Rate Govt Bond matching
maturity85% of companies use 10 year bond, Calculation ranges from spot, average and forecast
Market Risk Premium
Expected Compensation for market risk
Estimates range between 4% to 8%;Average in Australia ~ 6%; and based on range of domestic and global models;Average in US ~ 5%;Changes infrequently;
Beta Forward looking Beta Sourced from range of databases;Calculations vary as to period; range 0.2 0.3Little information on comparables choice
Target Debt Ratio Target Market Value weights
50% of companies still use book value weights
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Hurdle rates & WACC
A non risk adjusted hurdle leads to decline in quality of portfolio
Project Beta
Return
00
High
High
Company wide WACC
Risk adjusted Hurdle Rate
Low risk good quality projects that get rejected
High risk poor quality projects that get accepted
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RBA survey (2015) and Deloittes (2014) find that nearly 90% of companies use hurdle rates above 10%, with 40% of companies using hurdle rates > 13%
One third of respondents said hurdle was = / < WACC
For balance, hurdle was between 1% and 5% in excess of WACC average about 3% - 4% in excess of WACC
50% of companies said they rarely changed their hurdle rate
Results attributed to allowance for forecast optimism
Hurdle rates & WACC
Pervasive role of hurdle rates [#1]
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US Federal Reserve (2013) report that a sample of US companies have average hurdle rate of 14.1% (when BBB yields were 4%)
Hurdle rates has hardly changed in previous 10 years, in spite of interest rate declines
Higher growth firms have higher hurdle rates, and are less sensitive to interest rate changes because marginal returns are relatively attractive
Investment plans not sensitive to changes in interest rates
Hurdle rates & WACC
Pervasive role of hurdle rates [#2]
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Hurdle rates & WACC
Pervasive role of hurdle rates [#3] OECD find a decline in User Cost of capital has not driven uptick in G7 capital investment
Source: OECD Economic Outlook, Vol 2015, Issue 1, Chapter 3 Lifting Investment for Higher Sustainable Growth
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Kruger et al (2015) find evidence of companies using company wide cost of capital
Evidence of over-investment in high risk divisions, and under-investment in lower risk divisions
Translates into overpayments on acquisitions of about 8%
Evidence that it is simple use of a rule of thumb
Jagannathan et al (2013) find hurdle rates exceed WACC by up to 8%
Hurdle rates & WACC
Pervasive role of hurdle rates [#4]
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Hurdle rates & WACC
Framework for thinking about hurdle rates
Cumulative Capital Expenditure
NPV/Cost
00
High
High
Project Supply Schedule
WACC
Hurdle Rate
WACC
Value Maximising
Constrained
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Allowance for optimism:
Builds in gaming
Biases against long term projects
Not supported by evidence
Does it ix the issue?
Allowance for risk:
No basis for adjustment
Loses Transparency
Desire to earn greater than WACC
Value maximised by maximising value creation not ROIC or other ratios
Rule of thumb that has worked
Hurdle rates & WACC
(Dubious) Rationales for hurdle rates
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Preserve financial flexibility by avoiding going to capital markets, especially for marginal projects:
Cost of accessing markets easily adds 1% - 1.5% to required return
US survey finds financially constrained companies tend to have lower hurdle rates
Allowance for optionality:
Decision rules for options gross up required return for volatility, so only very in the money projects get accepted, others delayed
Decision rules incorporating options justify premium of 2% - 4% over WACC
Allowance for operational constraints:
US survey finds this to be most significant explanation
Hurdle rates & WACC
(Justifiable) Rationales for hurdle rates
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Impact of optionality on hurdle rate, assuming perpetuity American style
Volatiliity
Premium over Cost
00
40%
Hurdle Rates and WACC
15%10% 20%
20%
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How well do we address risk?
Do we focus too much on cost savings and efficiencies?
Do we understand and communicate the value creation track record
Addressing the challenge of being in Australia
Are there issues with public company ownership
Hurdle rates & WACC
Strategic Response to Hurdle Rate dilemma
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If hedging is shorter term, does it really change risk profile?
Financial hedging constrained by quantity risk
Can we really clarify exposures?
Can companies that need financial hedging use it?
Financial risks are a subset of organisation risk profile
Risk of a risk management disaster
Risk Management
Issues with financial risk management
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Insurance
Contractual protections
Portfolio hedging
Delay or abandonment options in projects
Risk sharing
Derivatives
Adjust financial strategy and absorb risk
Risk Management
The broader menu of risk management options
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Risk Management
Economic Capital may be a framework for thinking about risk trade-offs
Source: Specialty Guide on Economic Capital, Version 1.5, March 2004, Society of Actuaries, Illionois, United States
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The value contribution from gearing
Gearing
Net Benefit of Debt [% of EV]
00
6%
Risk Management
100%50% 150%
3%
Source: Binsbergen, Graham and Yang, Empirical Model of Capital Structure, 2011
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Minimum return = / ( 1)= 0.5 + (Rf )/ 2 +
[(Rf )/ 2 - 0.5 + 2Rf / 2 ]^0.5
Higher volatility, higher
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Skilling up
If you are interested in pursuing further study
Visit our website: www.mafc.mq.edu.au
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Risk Management
The value added of optimal gearing appears to be smaller
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Hurdle rates & WACC
Adjustments for risk vary
Component Best Practice PracticeSystematic Risk Should be based on
project comparablesBetween 30% and 50% of companies use company wide cost of capital;This leads to accepting high risk projects, and rejecting low risk projects deterioration in portfolio quality
Project Specific Risk Should be included in cash flows
30% - 50% of companies make adjustm
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