The Irrationality of Hurdle Rates: Experience and Expertise as Sunk Costs

The income method assumes that hurdle rates are rational. In the application of the income method the hurdle rate is the risk adjusted rate used in the discounting of cash flows to a present value. Click here for more on the income method. But is the application of hurdle rates rational? In this article I show that for most closely held businesses establishing a hurdle rate is irrational. 

It Takes Expertise and Experience to Run a Business

Buyers of small closely held firms, in addition to cash, must have a combination of sufficient expertise and experience to manage and operate the business. Expertise, experience, and cash are all forms of productive assets required for the successful operation of a business. Cash can be directly utilized to acquire expertise, but expertise and experience, once acquired, cannot be directly liquidated into cash. Conversion to cash can only occur if expertise and experience are utilized in the operation of a relevant business or professional practice. Acquiring the skill and experience needed to manage and operate a controlling interest in a closely held firm is always a time-consuming process; experience is by definition time consuming.

Expertise and Experience are Sunk Costs

This illiquidity of expertise and experience places constraints on investors. When cash flows turn out to be lower than desired, investors with the specialized expertise to operate in that specific service sector cannot simply shift their expertise to another service sector where returns might be higher. Similarly, if sector earnings become more volatile, and hence more risky, the investor with specialized expertise cannot simply switch the expertise to a different sector that has less volatility and less risk. This specialization, this non-transferability, combined with its illiquidity, explains why expertise and experience, once acquired, becomes a sunk cost.

Hurdle Rates Should Not Be Applied to Sunk Costs

As with any sunk cost, the first relevant question is whether the asset should be used or abandoned. Because the investor's expertise or experience cannot be directly liquidated into cash and invested into some less risky or more profitable investment, the investor has only one way to realize a return on these assets: utilize them. If the investor decides it would be better to use the skill and expertise, the critical question is how best to do this. The answer is clearly whichever option yields the highest marginal benefit. The emphasis must be on the adjective “marginal”.

The marginal benefit criterion stands in marked contrast to the hurdle rate or “risk versus return” criterion. The latter criterion states that no investment in a controlling equity interest in a closely held firm should be made unless a hurdle rate of return can be realized commensurate with the inherent risk of the investment. In contrast, the marginal benefit criterion states that it is prudent to invest in a controlling equity interest, if it is probable that the economic and psychological benefits are marginally higher than obtainable through an alternative use of accumulated expertise and experience.

For some examples of sunk cost fallacies from daily life click here.

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