Interest Rates and Capex: How the Hurdle Rate Reshapes Investment

For a decade after the 2008 crisis, money was almost free. Long-term government bonds in the United States and Europe yielded 1% to 3%, and in some years less than nothing. Capital budgets were built in that world. Then, between 2022 and 2023, central banks raised rates faster than at any time in forty years, and the ten-year US Treasury yield climbed above 4%. Many investment cases approved a few years earlier would not be approved today.

Interest rates reach capital expenditure through one number, the discount rate. Understanding how that number moves, and which projects are most sensitive to it, is one of the most valuable things FP&A can bring to a capital allocation committee.

From the central bank to the hurdle rate

The weighted average cost of capital (WACC) combines the cost of debt and the cost of equity. Both start from the risk-free rate. When it rises by three points, the cost of new debt rises by about the same, and the cost of equity rises unless the equity risk premium falls at the same time. A company whose WACC was 7% can find itself at 9% or 10% within two years without any change in its own risk.

Long-lived projects suffer most

The effect of a higher discount rate depends on when the cash arrives. A project that pays back in a few years barely notices; one whose value lies in cash flows ten or twenty years away loses most of it. This is the same duration effect that makes long bonds fall more than short ones when rates rise.

At a 6% discount rate, the 200 million infrastructure asset is the most valuable project on the list, with an NPV of 30 million. At 10%, it destroys 37 million. The six-year efficiency upgrade loses half its NPV but stays clearly positive. Higher rates do not cut investment evenly; they tilt the portfolio away from long-lived assets, such as plants, networks, energy and real estate, towards quick paybacks.

What happens to the pipeline

Across a pipeline of thirty projects, raising the hurdle from 7% to 11% cuts the capex that qualifies from about 1.1 billion to 0.5 billion, and the NPV of what remains from 367 million to about 100. This is the mechanism by which monetary policy slows the economy: not through any single decision, but through thousands of capital committees applying a higher number.

Practical consequences for FP&A

1. Update the WACC when markets move. A hurdle rate set five years ago and never revised either rejects good projects or approves bad ones. Surveys of CFOs by Ravi Jagannathan and colleagues found that corporate hurdle rates sit well above the cost of capital and rarely move with interest rates.
2. Show every case at several rates. The NPV at the current WACC, plus one and two points higher, tells the committee how much of the case depends on rates staying where they are.
3. Separate the financing from the project. Cheap fixed-rate debt raised years ago does not make a new project better; the project must clear today's cost of capital.
4. Revisit approved but unspent capex. Projects approved at 7% that have not started should be re-tested at the current rate. Stopping one is cheaper before the first payment.
5. Look for value in phasing and options. When rates are high, the value of waiting, of building in stages and of keeping flexibility rises. A smaller first phase with an option to expand often beats the full project.