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Cash & Working Capital

Capital Allocation Frameworks Needed

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April 05, 2018

NeuGroup surveys show that some companies don’t have a structured program to get to WACC or hurdles rates

Game planCapital allocation is an evergreen topic for NeuGroup members and a frequently requested topic for session discussions at peer group meetings. Interestingly, what’s often found in pre-meeting surveys is that companies don’t have a systematic framework for capital allocation models nor indications of which hurdle rates to use when.

Although at some companies, the capital allocation model may reside only in the head of the CFO, we found in pre-meeting surveys that the old reliable capital asset pricing model or CAPM, which uses a company’s own beta, is the most common method to calculate its weighted average cost of capital (WACC). About one in five members use their WACC for all hurdle rates while about half use WACC combined with other evaluation methods.

Despite being formulaic, WACC calculations may vary widely depending on who’s making the assumptions factoring into the formula. NeuGroup Peer Research polled its universe of treasurers and asked what was their “right” way to calculate WACC along with a what were best practices among peers in determining appropriate hurdle rates for capital projects.

The following takeaways are aggregated from approximately 100 company responses received during the second half of 2017 meeting season from the following NeuGroups: Treasurers’ Group of Mega-Caps (tMega); Treasurers’ Group of Thirty Large-Cap Edition (T30 LC); Treasurers’ Group of Thirty (T30); Tech20 Treasurers’ Peer Group (Tech20); Assistant Treasurers’ Group of Thirty (AT30), and Assistant Treasurers’ Leadership Group (ATLG).

Formula assumptions – where does the ambiguity dust settle? To get the most realistic picture of capital funding costs, and to see if return on invested capital exceeds it, aim to remove subjectivity from your WACC calculations. Per our surveys, almost three-quarters of respondents use the 10-year treasury as a risk-free rate; more than half use a market risk premium between 4-6% and a third calculates over a 5-year time frame. Most respondents obtain beta from Bloomberg.

WACC versus hurdle rates. About one in five members use their WACC for all hurdle rates, while half use WACC combined with other evaluation methods. While WACC may be the minimum hurdle rate for capital budgeting, it stands to reason that projects with higher risk should have higher hurdle rates to achieve desired return rates. A member from one of the lower-margin tech companies in the NeuGroup universe shared how his company is implementing a capital-allocation model based on WACC along with a certain profit level and four added risk premiums, three of which are market-driven: country risk; counterparty credit risk; industry/sector risk; and a non-market-driven legal risk (for example: if the company is involved in the design of a product and not just contract-manufacturing it for another party). Members were impressed with the level of detail of this approach (and the company’s customers in the respective peer group began to wonder how they stack up under the counterparty credit risk criteria!).

Questions remain on the “best way” to calculate hurdle rates and when changes should be made to either assumptions going into the calculations or calculation methods based on risk level, different businesses, geographies, time periods, etc., to increase the value-proposition of these rates. If hurdle rates should be adjusted for various reasons, processes should be in place to define the triggers/thresholds met/not met to increase transparency and consistency.

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