Firms are constantly deciding where to invest next. In 2015, S&P 500 firms spent $633 billion—about 6.3% of their revenue—on capital expenditures like purchasing equipment or upgrading facilities. This number does not include other forms of investment, such as investments in employee training, advertising, research and development, or even a retail store’s decision to carry a little extra inventory over the holidays.

But regardless of the type, size, or scope of the potential investment, one question is always paramount: How much of a return should a firm require? Just how profitable must an investment be in order to pull the trigger?

“There’s going to be some threshold,” says David Matsa, an associate professor of finance at the Kellogg School. “If the profitability is not high enough, then it’s not worth it to take that project.”

According to classical corporate finance theory, this threshold—often known as a hurdle or discount rate—ought to be pretty close to what an investor could earn putting the money toward a different project with comparable risk.

But in a new study, Matsa and Ravi Jagannathan, a professor of finance at Kellogg, find that firms in fact adopt more conservative criteria for funding new investments—turning down investment opportunities that would be profitable when evaluated on a stand-alone basis. Interestingly, the researchers find that cash-rich firms have the most conservative thresholds of all.

Why are firms opting out of so many profitable investments? In a word: bandwidth. New investments require more than just dollars—they require managerial oversight, as well as onboarding additional employees and training new parts of the organization to work together.

Higher Discount Rates

A firm’s discount rate is generally assumed to be its cost of financial capital, which many firms measure using their weighted average cost of capital, often referred to as WACC.

“It’s about opportunity cost to the firm’s owners,” Matsa explains. “If the firm wasn’t paying to build this new factory, they could instead pay that money out as a dividend and their shareholder could take that dividend and reinvest it in a different company. And so, the new factory needs to return at least as much as the investor would get investing that money somewhere else.”

Thus, the traditional thinking goes that if a firm has money to invest, it ought to take any and all investments that exceed this cost of capital, as turning them down leaves money on the table. “That’s what we teach in the introductory corporate finance class,” says Matsa.

Yet it is not clear that this is what firms do. In fact, when other researchers have surveyed firms in the past about how they evaluate new investment opportunities, they have found that firms report using higher discount rates than expected.

Why are firms opting out of so many profitable investments? In a word: bandwidth. New investments require more than just dollars—they require managerial oversight, as well as onboarding additional employees and training new parts of the organization to work together.

Higher Discount Rates

A firm’s discount rate is generally assumed to be its cost of financial capital, which many firms measure using their weighted average cost of capital, often referred to as WACC.

“It’s about opportunity cost to the firm’s owners,” Matsa explains. “If the firm wasn’t paying to build this new factory, they could instead pay that money out as a dividend and their shareholder could take that dividend and reinvest it in a different company. And so, the new factory needs to return at least as much as the investor would get investing that money somewhere else.”

Thus, the traditional thinking goes that if a firm has money to invest, it ought to take any and all investments that exceed this cost of capital, as turning them down leaves money on the table. “That’s what we teach in the introductory corporate finance class,” says Matsa.

Yet it is not clear that this is what firms do. In fact, when other researchers have surveyed firms in the past about how they evaluate new investment opportunities, they have found that firms report using higher discount rates than expected. 

“The cost of financial capital is important, but it’s not the only opportunity cost. There are more costs that should be accounted for.” —David Matsa

In the previous research, survey respondents were typically kept confidential, so it was impossible for researchers to match a firm’s stated discount rate to its cost of financial capital.

But in their study, the researchers sent their own survey to thousands of CFOs of US companies. They received 127 responses, each of which they were able to link to a specific firm. This allowed the researchers—who also included Iwan Meier of HEC Montreal and Vefa Tarhan of Loyola University of Chicago—to use public financial data to calculate the firm’s actual cost of financial capital.

They found that while the average cost of financial capital for these firms was about 8%, their average discount rate for taking on a new project was 15%.This provided strong evidence that firms tend to be relatively conservative about taking on new projects. 

“There’s a cost of financial capital that would come out of a textbook,” says Matsa. “What firms do is they add something to that. Instead of requiring a 12% return, they say, ‘If I’m going to take this, I need a 20% return.’”

A Bandwidth Issue

So why do firms insist on such a large premium in order to make an investment? Managerial and organizational bandwidth seems to be the root cause.

Indeed, many respondents directly stated that operational constraints affected which projects their firm could take on—and the numbers back up their assertions.

“We find that those who are saying they’re constrained organizationally, they are adding a higher premium than, on average, everybody else does,” says Jagannathan. New investments require funds, yes, but they also require managerial oversight. A lot of mental effort goes into tracking and supervising additional projects. Putting a talented employee in charge of one project means she is unavailable for a subsequent one. There is also the need for oversight at the highest levels of the organization. “Ultimately the CFO and the CEO of the company have to understand what’s going on,” Matsa says. “Their time is also a scarce resource.”

“Firms need to ensure that their capital budgeting process accounts for their available bandwidth.” —Ravi Jagannathan

Thus, practically speaking, a firm can only juggle so many investments. So the bar for deciding whether or not to invest is not merely the likelihood of profitability—it is the likelihood of a project being more profitable than other investments, some of which have not yet appeared on the horizon.

Cash-Rich and Choosy

The researchers also explored which firm characteristics affect discount rates. They discovered something interesting:  firms with a lot of cash on hand tend to use higher discount rates.

This may sound counterintuitive. After all, if a firm is not cash-constrained, shouldn’t it be most equipped to jump on any and every project that might be profitable?

Not so, says Jagannathan.

“Firms that hold a lot of cash are often growth firms. They hold cash because they expect to have a lot of investment options,” he says. These firms “have the flexibility to wait and take the best projects.”

This actually puts them in the best position to pass up lesser, though still profitable, investments. “Then, when the right opportunity comes, they’re able to move in fast,” says Jagannathan.

The researchers were able to rule out several alternative explanations for this finding, including the possibility that cash-rich firms had higher discount rates because it was difficult for them to raise additional capital. “We look at that and we find evidence against that idea,” says Matsa. In fact, they find that financially constrained firms added a lower premium to their cost of financial capital—suggesting they are not as choosy.

“Cash-poor and financially constrained firms tend to have fewer opportunities,” says Matsa. “They’re not as worried about saving some dry powder for when better opportunities come along.”

Avoiding Idiosyncratic Risk

The researchers’ analysis revealed another trend in when companies use a higher-than-expected discount rate: firms are more wary of taking on risk that is specific to their firm, or idiosyncratic, versus risk that is spread across the entire market, or systematic.

Think of it as the hypothetical difference between Apple’s Siri losing ground to Amazon’s Alexa versus Apple losing value because of a recession that hits all luxury goods.

A firm should theoretically prefer to take on projects heavy in idiosyncratic risk, because its shareholders can diversify their portfolios, mitigating the risk. “Think about Boeing and McDonnell Douglas bidding on defense contracts. One of them will get it and the other won’t. If you hold both the companies’ stocks, you’re indifferent,” says Jagannathan.

Yet the researchers found that firms in fact avoid idiosyncratic risk. “The firms are using a higher discount rate when there’s more idiosyncratic risk,” says Matsa.

Why is this? One explanation is that the managers are actively avoiding idiosyncratic risk in an effort to preserve their own careers and reputations. After all, if Siri falls to Alexa, Apple’s management team looks bad. If both companies are hit hard by a recession, the blame is much harder to pin down.

Finances Aren’t Everything

What are the takeaways from this research?

“The cost of financial capital is important, but it’s not the only opportunity cost,” says Matsa. “There are more costs that should be accounted for.”

Considering the human capital and organizational constraints necessary to see a new project through, it is probably wise for firms to have higher discount rates than their cost of financial capital would predict. “How much higher? It will depend on what opportunities are waiting,” says Jagannathan. “Firms need to ensure that their capital budgeting process accounts for their available bandwidth. If they are already stretched, or expect they might need to turn down opportunities in the future, they should apply a higher discount rate to potential projects.”