Though the bank rate has been on the floor since the financial crisis, corporate investment has seemingly not picked up. This is frustrating policymakers and suggests a market failure. After all, most companies of any size appear to follow the textbook when they make investment decisions, so surely if the cost of capital falls there should be more investment that is worth doing?
You can question this ‘puzzle’ on several levels. Firstly, the interest rate that companies are paying has not fallen as fast as the bank rate. Also, the focus of corporate investment continues to shift towards intangible assets, that are hard to observe in national income data. Nonetheless, I believe there is an underlying disconnect between corporate capital investment behaviour and the cost of capital.
The relevant interest rate for corporate capital investment is the real long-term rate – real because if falling nominal rates simply reflected inflation expectations that would be broadly neutral for investment. Since 2008, real yields on 10 year gilts have fallen by around 2%, to approximately zero, but the spread on corporate bonds has widened. These offsetting responses, in the riskless rate and in the yield on risky assets, are what theory would predict as investors seek safety after an extreme bad news event. The open question is how long the natural riskless rate will stay at this level.
Anyhow, and particularly as companies deliver, the main component of the weighted average cost of capital is the cost of equity capital, which is the interest rate plus the equity risk premium. Colleagues at London Business School – Elroy Dimson, Paul Marsh and Mike Staunton, who are the leading scholars in this area – argue convincingly that the equity premium hasn’t gone up since the crisis. In fact, I think you can argue that equity will earn a lower premium in this century than in the last.
So let’s say that overall, company costs of capital haven’t gone up and have perhaps fallen a little. But what do companies actually believe? The cost of capital is a topic that makes many CFOs uncomfortable. Often, when I ask CFOs what their cost of capital is, they either ask me the same question right back, or refer me to their adviser. In that world, beliefs about the cost of capital may be infrequently updated.
The real disconnect is in the investment committee. If, as I do, you regularly review company investment analyses you find that – though they may call it the ‘cost of capital’ – companies are using a hurdle rate for investment that is higher, and sometimes extraordinarily much higher, than their rationally-measured marginal cost of capital. Companies rationalise this in various ways. It is a counter to the over optimism of the people who submit the investment proposals. It reflects a loosely specified ‘risk premium’ to cope with these dangerous times.
Often it is that the company is already earning a return on capital that is well above the cost of capital, and wants to keep it that way – so the average becomes the marginal. ‘Soft’ or self-imposed capital rationing of this sort is widespread and comes with a preference for building the cash pile in the balance sheet and launching a share-buyback programme. This plays to what companies see as increased pressure from equity markets for management to signal ‘capital discipline’.
So policymakers are pulling the interest rate lever, or maybe it is pulling them. We can see the effect on personal finance. But in the world of corporate investment, and particularly for those successful companies you would like to invest more, it is not really connected to anything.