Is it worth the wait?

A company decides to invest in, say, an additional production line if the expected profit exceeds costs. In other words, the expected rate of return must exceed the company’s cost of capital. That is the theory, at least: fifty years ago.

In practice entrepreneurs have known for quite some time that the threshold to invest is markedly higher. According to a survey by former US Secretary of the Treasury Lawrence Summers CEOs discount project cash flows at rates amounting to three times the weighted average cost of capital!

Inversely, companies terminate loss-making projects only — and correctly — when revenue is far below (variable) costs. Textbook investment theory apparently deviates from entrepreneurial practice. Which crucial issue has been ignored? → Read More