The capital charge rate employed is also often referred to as a hurdle rate.
In particular, I compare the optimal required rate of return with the optimal capital charge rate and benchmark both these hurdle rates against the firm's cost of capital.
(4) In contrast to the ambiguous results for the required rate of return, the optimal capital charge rate under delegation always exceeds the cost of capital.
with [rho] denoting the capital charge rate. The compensation contract is given by:
(23) It now becomes apparent that two alternative interpretations of "hurdle rates" are conceivable: as the required rate of return R(k) = k/b - 1, or as the capital charge rate, [rho], under delegation.
The optimal capital charge rate exceeds the firm's cost of capital; that is, [rho]* > r.
Therefore, residual income corresponding to the capital charge rate of h is:
On the other hand, if the capital charge rate h equals the owner's cost of capital c, the manager will undertake the project whenever its net present value is positive, and reject the project when it is negative.
If the owner sets the capital charge rate equal to the hurdle rate [r.sup.0], the manager will adopt the optimal project acceptance decision described in the previous section.
At the same time, the manager will adopt the optimal project acceptance rule only if the capital charge rate equals r*.
Setting the capital charge rate h equal to the hurdle rate [r.sup.0] ensures that the manager invests optimally.
To ensure such consistent valuation, capital charge rates
for Departments must be increased (to yield pre-company tax rates) so that project valuations are at least approximately consistent with company tax paying entities.