How bad can short termism be?—A study of the consequences of high hurdle discount rates and low payback thresholds

Survey evidence suggests that hurdle rates used in DCF analysis are often considerably in excess of any plausible estimate of firms’ cost of capital, and that top level decision makers often impose additional short payback thresholds. This paper focuses on the value loss that can arise under such ‘s...

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Bibliographic Details
Published in:Management accounting research 2009-06, Vol.20 (2), p.117-128
Main Author: Dobbs, Ian M.
Format: Article
Language:English
Subjects:
Capital budgeting
Capital costs
Cash flow
Decision making
Discount rates
Firm budgets
Hurdle rate
Loss
Option value
Payback period
Risk
Risk adjusted discount rate
Short termism
Short-term analysis
Studies
Value
Volatility
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Summary:Survey evidence suggests that hurdle rates used in DCF analysis are often considerably in excess of any plausible estimate of firms’ cost of capital, and that top level decision makers often impose additional short payback thresholds. This paper focuses on the value loss that can arise under such ‘short termist’ decision criteria. It is shown that using such decision rules can help to protect the firm against the total value loss that can arise from the application of the naïve NPV decision rule, and that, for projects with growth prospects and/or moderate or greater volatility in future operating cash flows, the value loss (relative to ‘optimal decision-making’) which arises when firms impose fixed ‘short termist’ thresholds can be quite small.
ISSN:1044-5005
1096-1224
DOI:10.1016/j.mar.2008.10.007