Journal Article

Why do hurdle rates differ from the cost of capital?

Ciaran Driver and Paul Temple

in Cambridge Journal of Economics

Published on behalf of Cambridge Political Economy Society

Volume 34, issue 3, pages 501-523
Published in print May 2010 | ISSN: 0309-166X
Published online May 2009 | e-ISSN: 1464-3545 | DOI: http://dx.doi.org/10.1093/cje/bep013
Why do hurdle rates differ from the cost of capital?

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  • Manufacturing
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This article considers the role of hurdle rates in the analysis of investment decisions, analysing a sample of business units from the PIMS (Profit Impact of Marketing Strategy) databank of North American companies, which provides rarely observed data on hurdle rates. Although the standard literature suggests that firms should only invest if the return exceeds the cost of capital, there are several theories that explain the use of investment hurdle rates that differ from discount rates. In fact, our data show that instances where hurdle rates are either above or below the discount rate are common. In a statistical analysis, we find that this behaviour can be explained by a combination of agency theory and real options theory. We take this as important evidence that a full explanation of capital investment cannot be accomplished without a consideration of behavioural and strategic influences on the investment decision.

Keywords: Investment; Hurdle rate; PIMS database; Agency; Strategy; Real options; Governance; E22; G30; L20; L60

Journal Article.  8244 words.  Illustrated.

Subjects: Manufacturing ; Macroeconomics: Consumption, Saving, Production, Employment, and Investment ; Firm Objectives, Organization, and Behaviour ; Corporate Governance

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