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Emile comments on Bias in capital project decision making - Less Wrong

40 Post author: jsalvatier 26 May 2011 06:06PM

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Comment author: Emile 27 May 2011 12:55:11PM 2 points [-]

When I was in school, I noticed an odd thing: the interest rates that people used to evaluate projects on this basis, called the Minimum Acceptable Rate of Return (MARR), were often rather high, 15-50%/year. I saw this in textbook discussions and had it confirmed by several working engineers and engineering managers. My engineering economics teacher mentioned that firms often require two year "pay back periods" for projects; that annualizes to a 50% interest rate! I was very confused about this because a bank will loan a small business at ~8% interest (source) and mortgage rates are around 5% (source). This implied that many many industrial projects would be profitable if only outsiders could fund them, because investors should jump at the chance to get 15% returns.

Could taxes be a factor? If $100 of investment returns $50 benefits in a year, part of those benefits may be taxed before they could be used to pay back a loan (I don't know the details of how that would work out if the $50 benefits would be money saved, i.e. material that doesn't need replacing etc.).

Risk would also be a factor - even if you expect $50 benefits for $100 investment in a year, an exterior investor would have to factor in the chances that the company will go bankrupt. in his expected benefit calculation, whereas that doesn't feature in your calculation of the expected returns of the $100. And even assuming a honest assessment by the engineer, an exterior investor has to trust a longer chain of people than internal management does (and in addition, the external investor knows the involved people less, so has more uncertainty about how much they are exagerating).

So even if engineers always made perfectly accurate estimates, I would still expect taxes and risk to bring the "internal interest" to a lower value when it's considered by an external investor.

(Sorry, I'm not well versed in the vocabulary of economics and finance, I'm sure there's a better way of phrasing all this)

Comment author: jsalvatier 27 May 2011 01:41:23PM *  2 points [-]

Corporations are taxed on their profits (instead of their income) specifically to avoid discouraging investment in a perverse way.

Bankruptcy risk is certainly relevant, but its even more relevant for small businesses, which still have reasonable interest rates. If bankruptcy risk is what drives high MARRs that implies that a company that uses a 30% MARR has a ~20%/year default rate (30-10%) which is implausibly high.