Increased cost of capital and executive incentives

A simplified description of company’s weighted average cost of capital (WACC) is that it consists of the risk-free interest rate plus a risk premium for the company’s debt and equity. In this model the cost of capital, i.e. the return required by investors, should increase as interest rates go up.

This suggests that hurdle rates for new investments are expected to have increased in the current cycle of monetary tightening, with fewer investments being made as a result.

Shareholders want returns. Therefore, if companies are less likely to grow earnings by investing in new projects, It would be reasonable to expect executives to focus on improving operational efficiency instead. This has implications for executive incentive plans.

However, discount rates used by companies when assessing new investments may not have increased much despite a higher cost of capital, as suggested in a recent paper by Gormsen and Huber (see HERE).

The authors reviewed discount rates and cost of capital mentioned by executives in conference calls during the period 2002 to 2021. The paper shows that companies do change their discount rates when the cost of capital changes, but the change is typically less than one-to-one. On average, a 1 percentage point increase in the cost of capital leads to a 0.3 percentage point increase in the discount rate.

The study covered a period when interest rates largely declined and many companies in the sample rarely changed their discount rates when interest rates changed. Forty percent of companies maintained unchanged discount rates over a 10-year period.

That is, many companies used discount rates that were higher than the perceived cost of capital.

The authors find that many executives believe that high discount rates for new projects raise shareholder value, which is consistent with models where investors worry about overinvestment.

So while the cost of capital has increased in the current cycle, the actual discount rates some companies use may not have changed much. Nevertheless, boards may want to consider if higher interest rates have impacted hurdle rates for new investments. STI and LTI performance measures may need to be revised to incentivise executives to deliver growth by other means.

© Guerdon Associates 2024
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