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SEPTEMBER 2014

Bridging the gap between interest ratesand investmentsUnderstanding the weak links between interest rates,cost of capital, hurdle rates and capital allocation


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Published by Corporate Finance Advisory

For questions or further information,please contact:

Corporate Finance Advisory

Marc Zenner [email protected](212) 834-4330

Evan Junek [email protected](212) 834-5110

Ram [email protected](212) 622-5682


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2 | Corporate Finance Advisory

2. Rates, cost of capital, hurdle rates and project returnsThe typical investment decision-making process consists of three return components: theprojects Internal Rate of Return (IRR) or Return on Invested Capital (ROIC), the risk-adjustedcost of capital and the risk-adjusted hurdle rate (Figure 1).

(a) The expected returns of potential projects are widely acknowledged to vary witheconomic cycles. In some industries or for some projects, realized returns tend tobe close to expected returns. In sectors that are innovation or commodity driven, forexample, realized returns may vary materially from expected returns

(b) The cost of capital is the weighted average of the cost of equity and the after-tax costof debt. As a result, it depends on market dynamics. Most rms regularly re-estimatetheir cost of capital

(c) Firms typically use a risk-adjusted hurdle rate, not the projects cost of capital, tomake capital allocation decisions. The hurdle rate is the rate that decision makers feela projects return should be expected to surpass to be approved

Figure 1Investment decision-making process

While most practitioners agree that the hurdle rate should be greater than or equal tothe cost of capital, there is little agreement as to the size, if any, of the delta betweenthe two. Many rms tend to rarely, if ever, think about revising hurdle rates. Data discussedlater suggest that rms may be employing hurdle rates that are signicantly, and perhapsunjustiably, in excess of their current and long-term cost of capital.

Hurdle rateIRR/ROIC ?? > > Cost of capital=Evaluated for eachproject

Relatively easyto compute

Expected and realizedreturns may differ

Hopefully higher thanthe hurdle rate

Computation isnuanced andinfrequently performed Rarely, if ever,changed by rms

At least equal tothe cost of capital

Frequently evaluatedby rms

Relatively easyto compute

Estimates may varywidely, based onmarket risk premia

EXECUTIVE TAKEAWAY

Hurdle rates are critical to the corporate

capital allocation process. Most corporations,

however, pay very limited attention to hurdle

rates despite dedicating signicant resources

to project returns and cost of capital. Even

with todays unique market conditions, many

rms are still using hurdle rates set years ago.Is this practice driving the weak link between

interest rates and corporate investment?

Source: J.P. Morgan


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BRIDGING THE GAP BETWEEN INTEREST RATES AND INVESTMENTS| 3

3. Recent cost of capital variations through the cycle have

been small, but hurdle rates remain highWe estimate that the current median weighted average cost of capital (WACC) for S&P 500rms is about 8.5%, not far from the historical median of 8.3% (Figure 2). Despite todaysrecord-low borrowing costs, rms have not witnessed a material decline in their overall cost ofcapital. Low borrowing rates have been offset by a relatively at cost of equity and decreasedmarket-based leverage. The cost of equity has remained quite at because a persistentlyhigh market risk premium has continued to offset lower Treasury (risk-free) rates. Themarket leverage has declined as equity values have rebounded from their 20082009 lows.Interestingly, this dynamic suggests that rms may not face a material rise in the cost ofcapital when rates resume their expected upward trajectory.

To evaluate this idea, we simulated the future market risk premium and risk-free rate basedon their historical joint probability distributions. We computed the 2013 WACC bookendsbased on the 10th and 90th percentiles of our simulated WACCs. The 90th percentile was10.1%, suggesting that there is only a 10% probability that the S&P 500 WACC will be higherthan 10.1%.

Figure 2

Historical S&P 500 cost of capital (WACC) analysis

9.3%

9.5%9.0%

8.3%7.6%

6.7%

7.8% 7.9%8.3%

7.5%

7.6%8.0% 8.3%

8.3%

8.9%9.3% 9.1%

8.9% 8.8%

8.5%

10.1%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

8.2%

2013 WACC calculationat the 90th percentileof MRP and risk-free rate

Historical median WACC: 8.5%

2013 WACC calculationat the 10th percentileof MRP and risk-free rate

Source: J.P. Morgan, FactSet, BloombergNote: S&P 500 cost of capital calculated as the median of non-nance rms that have been trading for at least ve years; basedon ve-year historical betas calculated versus the S&P 500; risk-free rate based on yearly average; J.P. Morgan estimate of

U.S. equity risk premium based on dividend discount model; credit spreads are estimated using the Bloomberg FMCI; low andhigh range WACC determined as the 10th and 90th of WACCs obtained from joint simulations of the market risk premium andrisk-free rate based on their joint distribution over the last 20 years


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Many large rms rely on hurdle rates that are signicantly higher than their cost of capital.The median hurdle rate for a sample of S&P 500 rms reporting their target hurdle rates was18% (Figure 3). This target hurdle rate is signicantly higher than both the current medianS&P 500 WACC of 8.5%, as well as the simulated upper bound of 10.1%. Only two of these18 rms reported a hurdle rate close to its specic cost of capital. The median differencebetween the reported hurdle rate and our WACC estimate for this sample is approximately10%. Some rms may view the high hurdle rates as a sign of caution. As we describe in thenext section, we believe that an unreasonably high bar may actually be counterproductive tovalue creation, and, in some cases, increase risk.

Figure 3

Sample reported hurdle rates within Differentials between reported hurdlethe S&P 500 rates and costs of capital within the S&P 500

10%12%

15%17%17%18%

18%20% 20%

23%

25%27%

9%10%

13%

20% 20%

Non-cyclicals

Median hurdle rate: 18%

2%4%

4%

8%8%

9%10%11%

12%13%

16%18%

0%

3%

5%

13%13%14%

Cyclicals Non-cyclicalsCyclicals

Median differential rate: 10%

20%

Median WACC: 8.5%

Source: J.P. Morgan, company lings, investor presentations Source: J.P. Morgan, company lings, investor presentations

EXECUTIVE TAKEAWAY

A common refrain of rms looking to lower

hurdle rates is that they may have to increase

them in the near future once interest rates

are back to historical levels. This argument

seems fallacious since the cost of capital has

been roughly at through the recent cycle.

Going forward, rising rates are likely to be

accompanied by a decrease in the market

risk premium, limiting the increase in rms

WACCs. This provides rms with space to

lower their hurdle rates to levels sustainable

through economic cycles.


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4. The perils of high hurdle ratesConventional wisdom asserts that a higher ROIC leads to greater value creation, but thisprinciple does not always apply in practice. For instance, a rm may turn down a projectwith an IRR that is greater than its cost of capital, but less than its hurdle rate. Further, toohigh a hurdle rate can also lead to the pursuit of only higher risk projects and the gradualmigration to a higher overall risk prole. Potential consequences for ROIC of too high a hurdlerate include:

(a) A higher average ROIC, but value-creation potential may be lost. Over time the rm couldlack growth and either become subscale relative to peers or subject to takeover risk

(b) A lower average ROIC if unused capital is not returned to shareholders and the rm hasexcess underutilized capital

Evidence suggests that equity market investors look beyond ROIC. In Figure 4, we showthat valuation generally increases with excess return (dened as ROIC WACC). Beyond acertain point, however, an increase in ROIC WACC does not seem to lead to higher valuationmultiples. If anything, the highest ROICs seem to be associated with lower multiples. Firmswith the highest ROICs may not be able to nd enough projects to generate the growth prolethat leads to the highest multiples. These rms may therefore be able to boost valuationthrough lower hurdle rates. In contrast, about one-third of the rms do not generate ROICs

that exceed their WACC. In our view, this contrasting trend is not coming from too low a hurdlerate; rather, it likely results from project returns that turn out to be lower than expected returns.

Figure 4

Valuation versus excess return for S&P 500 companies

7.8x8.1x

9.9x 9.8x

8.8x

6.0x

7.0x

8.0x

9.0x

10.0x

15.0%

E n

t e r p r i s e v a

l u e

/ N T M

E B I T D A

Excess return (ROIC WACC)

31% 22% 15% 11% 6% 6% 10%Distribution:

8.2x

8.7x

Increasing ROIC beyond a certain level may be counterproductive

Source: J.P. Morgan, FactSet, BloombergNote: S&P 500 non-nancial rms; average NTM EBITDA over 1/1/201312/31/2013; average enterprise value over 1/1/201312/31/2013; WACC and ROIC as of 2013 YE

EXECUTIVE TAKEAWAY

The notion that higher ROICs, achieved throughhigher hurdle rates, are uniformly benecial ismisplaced. In todays environment, excessively

high hurdle rates can be counterproductive byleading to less growth and/or a riskier prole.Firms with the highest excess returns do notnecessarily have the highest valuation multiples.


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5. Capital constraints are not needed! Firms have nancial

exibility for both investments and shareholderdistributionsA common argument for high hurdle rates is that rms are capital constrained, i.e., thatthey lack capital to undertake all of their positive NPV projects. An articially high hurdlerate therefore helps management select only the very best projects. While this may be avalid argument for some rms and in some situations, we do not believe that capitalconstraints are an issue for most midsize or larger rms today. Indeed, as a result of post-crisis conservatism, the low cost of debt and trapped cash, many rms have ample nancial

exibility for transformative transactions. Figure 5 shows that cash levels are at recordhighs and net leverage at record lows for S&P 500 rms. In particular, the largest rmscan undertake once-in-a-lifetime acquisitions and debt-nanced distributions with minimalimpact on their ratings. 3 Investors welcome both types of strategies in todays growth-starvedequity markets. 4

Figure 5

Historical S&P 500 leverage and liquidity

3 For further reading on trends in corporate credit ratings, please see our December 2013 report The great migration: Evolvingmarket conditions transform the credit rating landscape found at:http://www.jpmorgan.com/directdoc/JPMorgan_CorporateFinanceAdvisory_GreatMigration.pdf

4 For further reading on positive market reactions to shareholder distributions and acquisitions, please see our March 2014 report2014 Distribution Policy: Challenging conventional wisdom about dividends and buybacks found at:http://www.jpmorgan.com/directdoc/JPMorgan_CorporateFinanceAdvisory_2014DistributionPolicy.pdf and May 2014 report 2014M&A Horoscope: The stars are aligned to bridge the $2 trillion M&A decit located at:http://www.jpmorgan.com/directdoc/JPMorgan_CorporateFinanceAdvisory_2014MAHoroscope.pdf

12.7% 12.3% 12.8%13.7%

20.8%

15.4%13.4% 13.7% 13.4%

10.9%8.9% 9.0% 8.2% 7.8% 8.3%

10.4% 11.1% 11.4% 11.5%

12.7%

Total net debt/(total debt + market cap) Cash and equivalents/total assets

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: J.P. Morgan, FactSetNote: Data includes highly liquid, cash-like assets held on balance sheet; excludes nancial and insurance companies;2013 or latest available

EXECUTIVE TAKEAWAY

Record-low net leverage means that

investments and shareholder distributions are

not mutually exclusive for most companies

today. Firms should consider both to unlock

shareholder value. In todays low interest

rate and growth-starved environment, both

debt-nanced shareholder distributions and

acquisitions are being rewarded.


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6. A framework for hurdle ratesToo high a hurdle rate might prevent a rm from undertaking value-creating investments.This approach may lead to lower growth, lower multiples, higher risk and, more importantly,foregone value-creation potential. It is critical for rms to optimize their hurdle rates giventhe abundant availability of capital and equity investors support for corporate proactivity. We outline a three-step framework for rms to develop and ne-tune their hurdle rates:

(a) Securing correct hurdle rate building blocks: Hurdle rates are often determined as therisk-adjusted cost of capital plus a risk premium or buffer. It is paramount to understandwhat the buffer captures and verify that the hurdle rate buffer is neither excessive normisguided. This buffer should capture the following:i. The fact that new projects are riskier than the rms assets in place today

ii. The need to generate some return over the cost of capital to create value iii. The desire to compensate for cash ow projection ination; that is, the fact that

cash ow forecasts are often too high The foregoing objectives should also ensure that a projects ROIC does not drop below

a specic level assessed to be critical to the market

(b) Sensitizing the hurdle rate: A through-cycle approach can help rms rene hurdlerates. As indicated in Figure 2, the cost of capital of a typical rm will likely not risesignicantly even if markets revert to historical interest rate conditions. As discussed,this is true because an increase in interest rates will likely be offset by a decrease in themarket risk premium in the absence of an increase in the rms market risk (beta). Thiscalculus should provide room for rms to lower their hurdle rates and still be abovetheir cost of capital in a normalized environment

(c) Understanding rmwide tactical and strategic implications arising from hurdle rates:Given their centrality in long-term planning, hurdle rates inuence corporate strategy. Forexample, a lower hurdle rate may allow rms to adopt a broader range of investments.

Lowering the hurdle rate, however, will also require a rm to revisit a host of objectives,including its current and forecasted capital structure, preferred modes of growth,shareholder distribution policies and risk management

Figure 6

Hurdle rate framework

SensitivityanalysisBuilding blocks

Tactical and strategicconsiderations

Interest rates

Market riskpremium

Capital structureShareholderdistributions

Growth strategy

H u r

d l e r a t e

Segments Geography New vs. existing

Inated estimates Market expectations Creating value

WACC

Buffer

EXECUTIVE TAKEAWAY

We provide a framework for a through-cycleapproach to hurdle rates. This frameworkshould guide rms that would like to re-assesstheir hurdle rates in this low-rate environment.

Source: J.P. Morgan


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Notes


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This material is not a product of the Research Departmentsof J.P. Morgan Securities LLC (JPMS) and is not a researchreport. Unless otherwise specically stated, any views oropinions expressed herein are solely those of the authorslisted, and may differ from the views and opinions expressedby JPMSs Research Departments or other departments ordivisions of JPMS and its affiliates.

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JPMorgan Chase & Co.) do not warrant its completeness oraccuracy. Information herein constitutes our judgment as ofthe date of this material and is subject to change withoutnotice.

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Copyright 2014 JPMorgan Chase & Co. All rights reserved.

We would like to thank Mark De Rocco, NicholasKordonowy, James Rothschild and Rob Stuhr fortheir invaluable comments and suggestions. We alsothank Jennifer Chan, Siobhan Dixon, Sarah Farmer,Ursula Jaroszewicz and the Creative Services groupfor their help with the editorial process. We areparticularly grateful to Allan Blair for his tirelesscontributions to the analytics in this report as wellas for his invaluable insights.


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