By Dwight Cass

The financial crisis cast doubt upon many “fundamentals” of financial theory and overturned market behavior expectations, making hurdle rate calculations a more subtle art. 

Aspiring MBAs in their first business school classes learn how to use a discounted cash flow analysis to determine whether a corporate investment will create value. The hurdle rate in Finance 101 is usually assumed to be the company’s weighted average cost of capital. In reality, it’s often some admixture of WACC and the expected return of the market—the risk-free rate plus the market risk premium (MRP). But since the financial crisis, setting the hurdle rate is a significantly more complicated, judgment-dependent and difficult undertaking than it once was.

Beyond acquiring the necessary market data and crunching numbers, treasury must determine how best to estimate the MRP, a task that was less onerous in less volatile times. Then, a regression analysis and some textbook calculations could generate a serviceable estimate.

Post-crisis, however, MRP estimation has become a multivariate probability exercise that is no longer based on unquestioned theoretical fundamentals, and therefore requires greater judgment. This may have contributed to an increase in the dispersion of the MRP used by US companies, as reported in an annual survey by Pablo Fernandez and Javier del Campo of the IESE Business School (Market Risk Premium used in 2010 by Analysts and Companies: a survey with 2,400 answers).

Fernandez found that the standard deviation of the MRP used by US economists had risen 20 basis points, to 2.4 percent, between 2008 and 2010. It was smaller among US companies, at 1.2 percent, but the actual rates diverged sharply among regions, with the US 2010 corporate average at 5.3 percent while the European corporate average was 5.7 percent.

Fernandez’s survey showed that companies most frequently use internal estimates of the MRP. Along with the risk of simply being flat-out wrong, internal estimates that rely on a good dose of judgment can be subject to internal pressures from entities with a stake in the outcome —a project’s champion, for example, or backers of another project that competes for resources with one under consideration.

While that has always been somewhat true, the hurdle rate calculation has now been complicated by fundamental changes in the theory underpinning MRPs, their empirical behavior and theoretical foundations, as well as the need to consider if and how to deal with market underpricing of the risk-free rate, and worries about what happens if that rate suddenly reverts to its long-term mean.

The hurdle rate isn’t the only calculation dogged by these factors. The discount rate used in corporate pensions calculations is likewise dependent on many assumptions that have been found wanting in the post-crisis period, as interest rates have been unprecedentedly subject to government manipulation.

The tension between the choice of a MRP to mix into the hurdle rate calculation—where an unduly high estimate can lead to a value-destructive dismissal of attractive projects—and the discount rate used when calculating the pension liability, where a higher rate reduces the current exposure, is one of the thorny and perennial issues treasurers must address.

Revolution in Rates

The financial crisis demonstrated the weakness of the assumptions undergirding many corporate finance decisions—weaknesses pointed out by academics (including the authors of the assumptions, such as Bill Sharpe and the Capital Asset Pricing Model). The seemingly basic concepts of diversification and the risk-free rate are once again topics of research, as observers have used the empirical evidence of the past four years to evaluate these 60-year-old ideas, and found them wanting (see “Realizing the Importance of a Risk-Free Rate,” IT, September 2010).

It took the financial crisis to alert many to the flaws in their models, even though Efficient Market Hypothesis wunderkinds Eugene Fama and Ken French proved that beta and return is not correlated back in 1992, in an article in the Journal of Finance. This should have been the death knell for CAPM, but it continued to be taught in business schools and widely used.

As recently as 2010, Aswath Damodaran, an academic at NYU’s Stern School of Business and a widely cited authority on equity risk premiums, wrote, “Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice.”

But after this straightforward set-up of the problem, he falls back on the discredited theories, writing: “The notion that risk matters, and that riskier investments should have higher expected returns than safer investments, to be considered good investments, is both central to modern finance and intuitive. Thus, the expected return on any investment can be written as the sum of the risk-free rate and a risk premium to compensate for the risk.”

Just Feels Right

This “intuitive” nature of the risk-return trade-off may account for the ongoing use of tools based upon it, buttressed by the fact that there are few other tools, and corporates and investors have to make decisions somehow. But the situation regarding those tools may be worse than if they were simply wrong; some argue that Markowitz, Sharpe, Fama and the other early high priests of the risk/return trade-off paradigm actually had the correlation exactly backwards: low-risk assets actually have the highest returns.

Robert A. Haugen and Nardin L. Baker, two quants, published a paper in 2008 that analyzed 45 years of stock return data. They concluded, “Stunningly, the ten percent of stocks with highest expected return, in aggregate, are low risk and highly profitable, with positive trends in profitability. They are cheap relative to current earnings, cash flow, sales, and dividends. They have relatively large market capitalization and positive price momentum over the previous year. The ten percent with lowest expected return (decile 1) have exactly the opposite profile, and we find a smooth transition in the profiles as we go from 1 through 0.”(“Case Closed,” The Handbook of Portfolio Construction: Contemporary Applications of Markowitz Techniques, edited by John B. Guerard Jr.)

Likewise, a theoretical gauntlet has been thrown down before the whole idea of a positive MRP. A growing number of analysts (and at least one notable Omaha-based investor) feel that corporates are using an estimate that is far too high. Eric Falkenstein, a quant and portfolio manager, notes that, “…with geometric averaging, survivorship bias to the US experience, taxes, transaction costs, and adverse timing, your average investor is at the discount rate Warren Buffett uses: long-term Treasuries.”

Falkenstein says that this view, that the MRP is actually 0 percent, isn’t as far out as one might imagine. He notes that Fama and French now put the MRP at 3.5 percent, while most textbooks in 1990 put it at around 8.5 percent. The difference between the two is about the same as the difference between the 2010 corporate average and 0 percent, and less than the difference between the Fama/French estimate and 0 percent.

Risk-Free or Just Risky?

The MRP isn’t the only component of the expected market return that looks unsettled. The risk-free rate itself is in question. Despite Buffett’s advocacy, the direction of long-term Treasuries is plagued by several uncertainties, including political issues related to raising the debt ceiling, the end of the second round of quantitative easing, the flip-flopping market expectations about inflation, and the change in sentiment among some important Treasury investors like Pimco.

Alternatives like a basket benchmark are feasible but certainly not risk-free. The euro, meanwhile, is under strain from the meltdown of the EU’s southern periphery. So corporates and investors are stuck for the time being with Treasuries. The potential for significantly higher volatility in that market makes calculating an expected rate of market return that much more of a crapshoot.

Treasurers therefore are faced with a conundrum. Compensating for uncertainty with a high hurdle rate estimate will filter out what might be attractive investments, and a higher discount rate penalizes distant project cash flows. Meanwhile, following Fama, Falkenstein or even Buffett may lock a company into low-return projects that drag on earnings if the MRP (and Treasury rate) end up much higher than expected. With these challenges, treasury’s judgment will certainly be put to the test.