(229)---CUT-OFF RATE

Cut-off Rate

In the implementation of a sophisticated project evaluation system, the use of a minimum required rate of return is necessary. The required rate of return or the opportunity cost of capital should be based on the riskiness of cash flows of the investment proposal; it is compensation to investors for bearing the risk in supplying capital to finance investment proposals.

Not all companies in Asian countries specify the minimum acceptable rate of return. Some of them compute the weighted average cost of capital (WACC) as discount rate. Unfortunately, all companies do not follow correct methodology of calculating the weighted average cost of capital (WACC). Almost all companies use the book value weights.

Business executives in Asian countries are becoming increasingly aware of the importance of the cost of capital, but they perhaps lack clarity about its computation. Arbitrary judgment of management also seems to play a role in the assessment of the cost of capital. The fallacious tendency of equating borrowing rate with minimum required rate of return also persists on the case of some companies. In USA, a little more than 50% companies have been found using weighted average cost of capital (WACC) as cut-off rate. In UK, only a very small percentage of firms were found attempting any calculation of the cost of capital. As in USA and UK, companies in Asian countries have a tendency to equate the minimum rate with interest rate or cost of specific source of finance. The phenomenon of depending on management judgment for the assessment of the cost of capital is prevalent as much in USA and UK as in Asian countries.