First, firms not only fund their investments with interest paying debt but also with equity. The overall cost of capital is the weighted average of the cost of debt (i.e. the interest rate, taking into account the tax deductibility of interest payments) and the cost of equity. Firms typically use (much) more equity than debt to fund their investments. The cost of equity is substantially higher than the cost of debt, because the cost of equity includes an risk premium that compensates investors for the volatility of equity returns. This equity risk premium is not fixed but varies over time. As a result, the cost of equity, and therefore also the weighted average cost of capital (WACC), is not closely tied to current market interest rates. This weakens the relation between interest rates and investments.
Second, when firms decide about an investment project, they often use a hurdle rate that is much higher than the estimated cost of capital. In a survey of US firms, Jagannathan and colleagues find an average hurdle rate of 15%, while the average WACC of these firms is only 8%. The hurdle rate also tends to be stable over time and firms care little about changes in interest rates. One reason why firms use such a high hurdle rate could be that they are financially constrained. That is, they cannot find enough funding to finance all valuable projects. As a result, they have to restrict themselves to the projects with the highest returns. However, Jagannathan et al. find that financially constrained firms actually use hurdle rates which are closer to their cost of financial capital, while firms with ample financial flexibility in the form of low debt ratios and high cash balances use higher hurdle rates. Their results suggest that it is nonfinancial, operational constraints, such as managerial or organizational requirements, that make firms more selective in making investments.
Interestingly, they also find that hurdle rates reflect idiosyncratic risk, i.e risk that is specific to individual firms. For example, the CEO of the firm might unexpectedly die, which could have large consequences for the firm, but matters little or nothing for the rest of the economy. According to standard portfolio theory, idiosyncratic risk does not affect investors who hold a diversified portfolio. If your portfolio consists of many different securities, the idiosyncratic risk of the different securities will cancel out if your portfolio is large enough. As a result, investors do not have to be compensated for idiosyncratic risk, and this risk should not affect the cost of equity. However, if the firm’s shareholders are not well-diversified, it makes sense to add a premium for idiosyncratic risk in the hurdle rate for investments: the shareholders need to be compensated for idiosyncratic risk that they cannot diversify away. Actually, many firms are controlled by shareholders which are not well diversified. Most firms are not listed on a stock exchange, and non-listed firms typically have a limited number of shareholders who have a substantial part of their wealth invested in an equity stake that they cannot easily sell. Even many (actually most) listed firms around the world are controlled by shareholders who have a substantial stake invested in the company. Idiosyncratic risk matters for those shareholders, and it makes sense to take it into account when setting the hurdle rate for new investment projects.
Finally, the value of investments not only depends on the required rate of return, but also on the expected return of investment projects. If there are fewer good investment opportunities in times when interest rates are low, firms in the aggregate will invest less even if it is apparently cheap to invest. So, the current lack of investments may also reflect a (perceived) lack of good investments opportunities.
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