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.