The Reserve Bank has uncovered why businesses have been so reluctant to invest recently. For months, the RBA has failed to raise the level of spending in the economy by fiddling with interest rates. What reason did the RBA find for their failure? Strikingly, they revealed that interest rates rarely factor into a company’s decision to invest.
What businesses look at instead is the so called ‘hurdle rate’. This refers to the rate of return businesses expect to make on future investments. For over 90% of companies surveyed, the rate of return is above 10%. Unless the hurdle rate exceeds this figure, most firms tend to put off investing.
This must come as a bitter pill to swallow for the RBA. After all, increasing business spending was their main aim in lowering rates. It only highlights how ill-advised, and ineffective, their rate cutting has been.
With mining revenues falling sharply, the RBA looked to non-mining sectors to take up the slack. Yet despite cheaper borrowing terms, new investments haven’t materialised. What we’ve been left with instead is lacklustre business sentiment. Businesses predict they’ll be cutting spending by $100 billion over the next year.
So investment opportunities need to meet stringent hurdle rates companies have in place. Lower borrowing costs only raise concerns over potential returns on investments. The fear is that they won’t be enough to offset capital expenditures.
But there’s an even bigger disconnect here.
The RBA found that most companies have stuck with long-term hurdle rates. Often these were calculated at a time when interest rates were between 4–6%. In today’s era of 2% rates, that’s a problem. Companies are overlooking that the rate of return may be smaller in a low interest rate environment. Instead, they’re still applying standards set years ago to calculate current hurdle rates. That’s making it more difficult to convince businesses to spend. And it’s why the RBA want to see expectations adjusted downwards.
Why the hurdle rate is so important for new investments
The important thing to realise here is that the rate of return is taken seriously by investors. If shareholders see diminishing returns on their investments, they’ll go elsewhere.
That leaves companies with a straightforward decision to make. Either risk the wrath of investors, or return any cash straight back to them. Most companies, unsurprisingly, play it safe by returning cash to investors. It’s much better in the short term to pay out dividends if the hurdle rate doesn’t meet shareholder expectations.
That’s why the RBA is arguing investor, and company, standards need to change. The RBA says the economy won’t grow unless firms ‘lower expectations for future growth and risk’. So they suggest businesses will need to lower their hurdle rates to match the current interest rates. But the prospects of that happening are slim.
The RBA acknowledges that corporations rarely recalculate hurdle rates. They cite a couple of reasons for this. Among them is the fact that any change to the hurdle rate requires a board’s approval. Since boards represent their shareholders, that doesn’t bode well for any imminent change.
Another factor relates to the amount of time it takes to achieve a return on investment. The ‘payback period’ is commonly set at three years for many companies. Typically, projects that take longer than that fail to get approval. But the payback period is sometimes as short as one year for some businesses. That makes it difficult to get new projects greenlit.
The importance of hurdle rates to business decision making adds to the uncertainty over the economy. Growth rates won’t improve unless non-mining investments pick up. But unless consumer confidence lifts, the hurdle rate will remain an obstacle to spending. Unfortunately, that suggests a sustained period of gradual decline for the Australian economy.
This is something The Daily Reckoning’s Greg Canavan has been warning us about for months. As one of Australia’s leading investment analysts, Greg says we’re sleepwalking into a recession.
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Contributor, The Daily Reckoning