Sunday, June 21, 2015

Sunday Essay - the RBA on the reasons why lower interest rates don't presently lead to more investment

I do like the Reserve Bank of Australia. The Bank has come to fill the role that the Commonwealth Treasury once filled, the provision of relevant economic analysis that one can read without worrying about the political overlay. I mention this now because the June Quarter RBA Bulletin carried a very useful research report by Kevin Lane and Tom Rosewall simply entitled Firms’ Investment Decisions and Interest Rates.

One of the issues that I and others have been concerned about is the apparent investment strike that has been underway for a number of years. We have businesses with cash, we have very low interest rates, and yet business investment is at relatively low levels. We also have businesses that have been paying out an increasing proportion of profits in dividend, again implying that the investment options aren't there. Kevin Lane and Tom Rosewell examine these conundrums by examining the way that firms make investment decisions.

 The summary reads:
Firms typically evaluate investment opportunities by calculating expected rates of return and the payback period (the time taken to recoup the capital outlay). Liaison and survey evidence indicate that Australian firms tend to require expected returns on capital expenditure to exceed high ‘hurdle rates’ of return that are often well above the cost of capital and do not change very often. In addition, many firms require the investment outlay to be recouped within a few years, requiring even greater implied rates of return. As a consequence, the capital expenditure decisions of many Australian firms are not directly sensitive to changes in interest rates. Furthermore, although both the hurdle rate of return and the payback period offer an objective decision rule on which to base expenditure decisions, the overall decision process is often highly subjective, so that ‘animal spirits’ can play a significant role. 
I will leave you to read the piece in full, it's not complicated, but just a short head's up.

Firms look at the expected rate of return to determine the expected value of an investment. This is an absolute number that has nothing to do with the weighted cost of capital as such. The hurdle rate is is the percentage return that must be achieved before a firm will invest. The expected yield is the difference between the projected return and the weighted average cost of capital.

You would expect a rise in yield to increase investment. In other words, if interest rates or indeed tax rates go down and yield rises, you would expect investment to increase. However, if the hurdle rate is fixed or adjusts very slowly, if that rate is calculated independently of funding costs or indeed taxation impacts, rises in yields may have no investment impacts.

The use of pay-back periods in combination with hurdle rates compounds the problem. The pay-back period, the time required to recover costs, is a risk measure. When times are uncertain, you want your cash back more quickly. So investments have to pass two tests: will I get the rate of return I want; will I get my cash back in the time I want? The practical effect is to increase the required rate of return beyond the hurdle rate.

I leave it to you to read the paper. My thanks to Kevin Lane and Tom Rosewell for their work.



Anonymous said...

Of course it's not just about the current yield, it's also about confidence, the expectation that the yield will remain high into the future. As well documented in the Westpac and other surveys, business confidence has spiralled downwards from the moment this government took office and consumer confidence hasn't been great either.

What people who understand basic LNP ideology expected is exactly what we have got: cuts to the budget acting as cuts the economy; no improvement in the debt and deficit because the spending cuts hurt revenue; rising unemployment; worse pay and conditions; and retail reeling.

Winton Bates said...

Jim, I agree with your assessment of the paper.
I suspect that the substantial margin between the hurdle rate and cost of capital may reflect tax systems that encourages firms to rely more heavily on debt at the expense of equity funding. If you rely heavily on debt it makes sense to have a conservative approach to investment appraisal to avoid putting the survival of the firm at greater risk.

Winton Bates said...

A further thought, the finding that the hurdle rate is relatively insensitive to changes in interest rates is consistent with something I might have been told long, long ago about Keynes' view that the mec schedule was relatively insensitive to interest rates. You would know more about that than I do.

Jim Belshaw said...

Hi anon. Without getting into a political argument, expectations do affect things and in particular views on risk.

Winton, the way that firms are presently calculating is not (to my mind) linked to tax systems. Both hurdle rates and payback period are independent. The cost of different funding mechanisms and indeed the availability of immediate cash comes in next.

Anonymous said...

Accepting the learnedness of all that, why is it not possible to provide an equally lucid essay upon what actually leads to more investment? And then maybe act upon it.

"the RBA on the reasons why XXX leads to more investment" would be much more interesting.


Jim Belshaw said...

That's a fair question, kvd, but one I have been struggling to answer. If the combination of high hurdle rates with short payback periods is the present cause, then you have to change firm behaviour. The Bank has been trying to say invest more, but that hasn't worked.

I suppose that they could try a research paper along these lines. Mathematical modelling suggests that firms that under invest will deliver lower shareholder returns. If all firms do this, then growth as a whole will be slower and all firms will suffer. The modelling also suggests that current stock values are unsustainable in the absence of additional investment.