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By Dario Gatti, CFA and Daniel Flores, PhD.

Discount rates sit at the center of many valuation analyses. In theory, corporate finance textbooks suggest that future cash flows should be discounted using a firm’s cost of capital, often estimated through the Capital Asset Pricing Model (CAPM) and the resulting Weighted Average Cost of Capital (WACC). In practice, however, investors rarely rely on these figures when deciding whether to commit capital.

In our recently-completed paper, we examine a simple yet important question: how do firms actually decide whether an investment is worth making?

Empirical evidence shows that companies rely on hurdle rates—minimum acceptable returns that projects must meet before proceeding. These are pragmatic decision thresholds used by management and boards, not theoretical constructs. Survey evidence and public statements by executives consistently show that hurdle rates are materially higher than CAPM‑based WACC, typically by 3.5% to 6%.

This gap is not accidental. Firms apply higher required returns to reflect forecast risk, uncertainty, capital constraints, and the difficulty of reversing investment decisions. Hurdle rates also tend to be stable over time, allowing firms to apply consistent standards rather than reacting mechanically to changing market inputs.

The implication for valuation in arbitration and litigation proceedings is straightforward: mechanically applying CAPM‑based discount rates can produce values that do not reflect how investors actually assess risk and return, resulting in overstated valuations. When real‑world evidence on investment decision‑making is available, it provides an important reference point for understanding how assets and projects are evaluated in practice.

The full paper, “Cost of Capital, Hurdle Rates, and Discount Rates: Textbook Corporate Finance v. Real‑World Investment Decisions,” is available here:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=6460039