Using Multiple Cutoff Rates for Capital Investment
Authors: Lyon J.R. 
Published: December 2007

Capital-budgeting systems commonly are based on a single cutoff rate, but the use of multiple cutoff rates has been suggested frequently. The nature of the capital-budgeting process and the reasons for using the single cutoff rate are discussed to provide a perspective for examination of three suggestions for using multiple cutoff rates.

Introduction

The term cutoff rate is used in capital budgeting to refer to the practice of selling a threshold rate of return that a project must reach or exceed if it is to be accepted. If a firm uses different threshold rates for different classes of investment, it is said to use multiple cutoff rates. Capital-budgeting systems based on a single cutoff rate are commonly used, but frequent suggestions have been made in the literature for the use of multiple cutoff rates. It is the purpose of this paper to examine these suggestions to determine the implications of changing present practices. The nature of the capital-budgeting process and the reason for using the single cutoff rate are discussed first. This provides a perspective for discussion of three separate suggestions for using multiple cutoff rates. It is apparent that two of the suggestions are not criticisms of the fundamental theory; they axe put forward to improve its practical application. The need for multiple cutoff rates in these contexts can be obviated by correct application of the single-rate theory; nevertheless, with proper safeguards, some practitioners may find the proper safeguards, some practitioners may find the suggestions useful. The remaining criticism is more fundamental; it is that the single cutoff rate neglects investor risk aversion. This criticism is based on the observations that the cost of capital vases between industries and companies in away that is, in some sense, related to risk. This criticism is valid, but practical application is rather limited. While the conclusions on the use of multiple cutoff rates are somewhat negative, the study has provided an unexpected bonus. It was necessary to re-examine the question of how to calculate the cost of capital and how, precisely, risk affected the calculation. For this purpose, a model based on investment theory was used that may provide more definitive estimates of the cost of capital than present techniques.

The Capital-Budgeting Process

Through the capital-budgeting process, a company decides three main questions: how large the budget should be, what assets should be included, and how the budget should be financed. Such questions are clearly fundamental to the progress of a company. Moreover, the answers must be found progress of a company. Moreover, the answers must be found in spite of uncertainty about consumer requirements, the action of competitors, obsolescence caused by new products or processes, the national economy, and changes in government regulation. Because of its complexity, the capital-budgeting decision falls in the class of decision-making that Simon has called "nonprogrammed." It can be characterized as nonroutine and ill-structured, and it requires judgment, intuition, and creativity. The ability of a company to make sound decisions in this area rests not so much on techniques as on how well it has selected and trained the executives who will screen the available data and make judgments.

JPT

P. 822