The Committee That Decides Which Projects Get Money
Capital spending requests compete against each other and against a minimum return the company sets. How that threshold is chosen determines what gets built.
Capital Is Rationed on Purpose
A company generates cash and has more uses for it than it can fund. Capital expenditure, spending on assets that will produce benefit over multiple years, is therefore allocated through a formal approval process rather than left to individual managers.
The typical structure has approval limits by level. A plant manager can approve small replacements, a division head can approve mid sized projects, and anything above a threshold goes to a capital committee or the board. This is partly control and partly an attempt to make sure large commitments get scrutiny proportional to their size.
The Hurdle Rate
The hurdle rate is the minimum return a project must be expected to earn to be approved. Conceptually it should be anchored to the company weighted average cost of capital, the blended cost of the debt and equity funding the business, because a project earning less than the cost of the money used to fund it destroys value.
In practice most companies set the hurdle above their cost of capital, often substantially. If the calculated cost of capital is 8 percent, the hurdle might be 12 or 15. There are two reasons, one defensible and one less so.
| Reason for the premium | Assessment |
|---|---|
| Project forecasts are optimistic | Defensible, if optimism is systematic |
| Capital is genuinely rationed | Defensible, ranks projects against each other |
| Nobody wants to lower it | Inertia, not analysis |
A hurdle rate set well above the cost of capital is a tax on the optimism of the people writing the proposals. That is reasonable, as long as everyone knows that is what it is.
The Optimism Problem
Capital requests are written by people who want the project approved. Benefits get estimated generously, costs get estimated tightly, and the timeline assumes nothing goes wrong. This is not usually dishonest. It is the natural result of asking an advocate to produce the forecast.
Raising the hurdle rate is the crude correction. The better correction is to compare completed projects against their original business cases and find out how large the bias actually is, then apply the correction with evidence rather than by feel. Very few organisations do this consistently, which is why the hurdle rate ends up carrying the whole burden.
What Gets Distorted
A single high hurdle applied to every project has a specific effect: it favours projects with fast payback and penalises long lived ones. A discount rate compounds, so a benefit arriving in year eight is discounted far more heavily at 15 percent than at 8. Infrastructure, capacity that will run for decades and long horizon research all look worse.
Short payback projects, cost reductions and quick capacity debottlenecking look better. Over years this produces a company that has systematically underinvested in long lived assets while reporting that it applied consistent capital discipline.
The partial fix is to use different hurdle rates for different risk classes. A mandatory safety or regulatory project should not be evaluated against the same threshold as a speculative expansion, because it is not optional and its risk profile is different.
Maintenance Versus Growth
Most capital budgets separate maintenance capex, spending required to keep existing operations running, from growth capex, spending intended to expand. The distinction matters because maintenance is not really discretionary. Equipment wears out, and deferring replacement borrows from the future at a bad rate.
Where this gets abused is in classification. Labelling a replacement as growth makes the growth number look better. Labelling growth as maintenance protects it from scrutiny. Analysts examining a company generally want to know true maintenance capex, because free cash flow after maintenance is a better picture of what the business generates than the headline number.
The Approval Is Not the End
The weakest part of most capital processes is what happens after approval. Money is committed, the project proceeds, and no one systematically checks whether the promised return arrived. Without that loop, the estimates in the next round of proposals face no accountability, and the optimism bias persists indefinitely.
The Bottom Line
Capital allocation is where a company decides what it will become, and the hurdle rate is the single number that shapes the outcome. Set it near the cost of capital and optimistic proposals get funded. Set it far above and long lived investment gets starved while the discipline looks admirable. The more durable answer is to reduce the optimism at the source by measuring what past projects delivered, so the threshold can do its actual job instead of compensating for forecasts nobody checks.