David McDonald considers the current low interest rate environment and asks whether this justifies lower hurdle rates for investments?
Boards are responsible for many functions, however key among them is to ensure that organisations are managed for the long term and that decisions made by their organisations create enduring value. Strategy formulation and policy formulation therefore need to reflect this overarching objective. A fundamental role of the board is to ensure that management is continuously aiming for above- average performance taking account of risk. Acceptable levels of risk to an organisation are reflective of the risk appetite set by the board and agreed with by management. They are also encapsulated in an organisation’s investment hurdle rate, which reflects the expected returns of shareholders and the cost of debt funding provided by lending institutions.
Capital allocation is a senior management team’s most fundamental responsibility. Capital can be used for investment in expansions or new projects, mergers and acquisitions (M&A) and research and development (R&D). Alternatively it can be returned to shareholders as dividends or via buybacks. The ultimate aim of course is to build long-term shareholder value. Academic research has shown that rapid asset growth is associated with poor shareholder returns. There is no easy answer to these difficult decisions.
Globally governments of all persuasions are pushing for companies to invest and boost growth. Locally, the Reserve Bank of Australia (RBA) has regularly commented that a pickup in investment from the non-resources sector is needed to replace the big drop in mining capex and to ensure continued growth in our economy. Politicians seek investment to generate economic growth and jobs. Managements can be swayed by the desire to grow and be part of a bigger organisation. Banks are also keen to boost lending from what has been historically low levels and might therefore encourage companies to consider accepting higher debt levels. On the other hand, shareholders are often pushing for funds to be returned via dividends or buybacks.
Boards are the ultimate guardians of the use of company funds. They need to balance all of these competing demands and ensure that seemingly compelling cases for investment from management do indeed “stack up”.
Equity risk premia
In considering hurdle rates for proposed investments, companies must take into account the cost of both debt and equity. Globally the cost of debt is certainly at historically low levels making borrowing appear more attractive. The macro-economic reasons for this are however an important consideration and are discussed later in this article.
Using this data series, its authors have been able to calculate historical equity risk premia (ERP). ERP or betas are often used as part of calculating an appropriate cost of capital or required hurdle rate for investments. One of the more interesting findings from the yearbook is that Australia has historically had one of the highest ERP, which perhaps reflects the more volatile nature of our commodity-based economy.
In considering hurdle rates for proposed investments, companies must take into account the cost of both debt and equity.
However, the Australian equity market has also provided the second-highest total return over the past 115 years. Thus this market has delivered a higher return, which has been needed to satisfy the higher ERP. The research shows that over the 115-year period, the premium for Australian equities over bonds is 5 per cent, however in contrast, over the past 50 years it has only been 3 per cent. For the US, the long-run ERP has been 4.3 per cent and for the UK 3.7 per cent. The authors of the Credit Suisse Year Book conclude that while risk appetite changes in the short term, long-term required returns probably do not.
However, given increased scope for diversification and adjusting for what they believe to be non-repeatable factors, they estimate the future required equity premium is likely to be lower. For those looking to use beta in calculating an appropriate hurdle rate, it is unlikely that risks have changed. Volatility will always be with us. Risks such as new technologies, geo-political events and new competitors have always existed and are likely to continue to provide challenges for businesses in the years ahead. What appears to be holding back investment spending in Australia at present is not high discount rates but rather a lack of confidence in the outlook. Businesses need to believe that the required returns will be there to justify any spend.
Question the returns
Research by Credit Suisse Australian equity strategist Hasan Tevfik has shown that historically share prices of Australian companies that have spent less on capex have outperformed those that spend more. The main reason for this is that the big spenders have tended to generate poor returns on their invested capital. Similar conclusions were reached in a recent publication by renowned finance academics Fama and French who found that low investment spending and low asset growth create leaner companies that are more profitable in the long run.
While boards have to consider competing demands for dividends and calls for growth, perhaps a second thought on expected outcomes is called for before taking the plunge to invest in new projects. Australia has seen several high-profile growth projects that have not gone to plan in recent years despite best intentions. Many local companies successfully expand and invest overseas either through organic means or M&A. We have many companies that are now global leaders in their fields thanks to this investment.
One of the reasons that interest rates are currently low in most developed economies is the expectation that both inflation and economic growth will be lower in coming years than historical averages. This implies that boards should be thinking of likely lower returns from projects they are assessing. A lower hurdle rate due to cheap debt or lower discount rate should be considered alongside lower projected cash flows than might have historically been the case.
The bottom line here is that applying a lower discount rate to what might be lower than expected cash flows is likely to give a similar net present value to projects having a higher discount rate but higher cash flows.
One of the key reasons for this is demographic change and the ageing population in most developed economies. An ageing population and lower birth rate implies a lower potential growth rate unless we can find ways to provide a significant boost to productivity.
Boards need to ensure that projected revenues and growth rates take into account this new environment.
Low inflation is also perhaps here to stay as a long-term factor due to demographic trends and rapid technological change. This has resulted recently in calls for the RBA to reconsider its 2-3 per cent inflation target rather than cutting rates. This means that nominal revenue growth is likely to be lower in coming years than has historically been the case.
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