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Cambridge Journal of Economics Advance Access published online on May 7, 2009
Cambridge Journal of Economics, doi:10.1093/cje/bep013
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© The Author 2009. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.

Why do hurdle rates differ from the cost of capital?

Ciaran Driver and Paul Temple*

* Imperial College Business School, Imperial College London, UK and Department of Economics, University of Surrey, UK, respectively

Address for correspondence: Ciaran Driver, Imperial College Business School, Imperial College London SW1 2AZ, UK; email: c.driver{at}imperial.ac.uk

This article considers the role of hurdle rates in the analysis of investment decisions, analysing a sample of business units from the PIMS (Profit Impact of Marketing Strategy) databank of North American companies, which provides rarely observed data on hurdle rates. Although the standard literature suggests that firms should only invest if the return exceeds the cost of capital, there are several theories that explain the use of investment hurdle rates that differ from discount rates. In fact, our data show that instances where hurdle rates are either above or below the discount rate are common. In a statistical analysis, we find that this behaviour can be explained by a combination of agency theory and real options theory. We take this as important evidence that a full explanation of capital investment cannot be accomplished without a consideration of behavioural and strategic influences on the investment decision.

Key Words: Investment • Hurdle rate • PIMS database • Agency • Strategy • Real options • Governance

JEL classifications: E22, G3, L2, L6

Manuscript received June 13, 2008; final version received February 24, 2009.


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