Capital investment requires clearing a rising financial hurdle

Before committing billions to new manufacturing plants or equipment, companies perform financial calculations designed to answer a single question: Will this investment return more than it costs? The methods businesses use to answer that question have remained stable for decades, but the calculations themselves shift whenever interest rates move.

The primary metrics—net present value, internal rate of return, and payback period—measure whether future cash flows from an investment justify its present cost. A company's decision to proceed depends on clearing a hurdle rate, a minimum acceptable return threshold based on how much capital costs to raise. When interest rates rise, that hurdle gets higher, and projects that looked profitable before may no longer justify approval.

Three metrics dominate capital budgeting

Surveys of CFOs show that these three metrics remain standard practice across industries for evaluating capital investments. The three methods approach the same question from different angles.

Net present value calculates whether a project creates value by converting all future cash flows into today's dollars using a discount rate, then subtracting the initial cost. A positive NPV indicates value creation. Internal rate of return expresses the same calculation as a percentage—the discount rate at which a project's NPV equals zero—making it easier to compare projects of different sizes. Payback period measures the simplest metric: how many years until cash inflows recover the initial investment, offering a rough check on project risk and liquidity.

The frequency with which CFOs use these methods reflects their utility. Discounted cash flow analysis, the family of methods that includes NPV and IRR, remains standard practice. Academic research shows CFOs with MBAs tend to favor NPV more than those without, but all three metrics remain standard practice across industries.

Discount rates bridge interest rates to investment decisions

All three metrics depend on a discount rate—the interest rate used to convert future cash flows into present value. A common approach is the weighted average cost of capital (WACC). WACC reflects what a company must pay to raise capital from both lenders and shareholders, calculated by weighting the cost of equity and cost of debt by their proportions in the company's capital structure.

Interest rates shape WACC directly. When Federal Reserve policy keeps rates low, the cost of borrowing falls, WACC declines, and future cash flows appear more valuable in today's dollars, making more projects pass the financial test. When rates rise, as they have since 2023, the opposite occurs. A manufacturer evaluating whether to spend $100 million on new equipment will calculate very different returns depending on whether WACC is 5 percent or 9 percent.

The Federal Reserve maintained elevated interest rates through 2025, with plans for rate adjustments. This elevated level, compared to the near-zero rates of 2020-2021, has raised the cost of capital for companies across industries, pushing up the financial hurdles they must clear before committing to major investments.

The hurdle rate sets the minimum acceptable return

Beyond WACC, companies establish a hurdle rate—the minimum return a project must achieve to be approved. Most firms calculate hurdle rates by adding a risk premium to their WACC. If a company's cost of capital is 7 percent and it adds a 4 percent risk premium for uncertainty, the hurdle rate becomes 11 percent. Any project expected to return less than 11 percent faces rejection.

According to recent surveys, 62 percent of organizations use their calculated cost of capital as the hurdle rate, while 38 percent set it higher to account for additional risk tolerance or strategic priorities. The higher the hurdle, the fewer projects clear it. Rising interest rates increase WACC and therefore increase the hurdle rate, functionally tightening capital allocation.

Hurdle rates serve as an objective filter against subjective spending decisions. But the metric has practical limits: determining the appropriate risk premium can be challenging, and a project with lower percentage returns may deliver higher net present value if its cash flows are large or certain enough to offset a lower return percentage.

Manufacturing shows how interest rates affect real spending

Manufacturing investment offers a concrete example of how these metrics drive spending decisions. Two of every three manufacturers planned to increase equipment investments in 2025, with median spending up 34 percent from 2024, according to industry surveys. Major commitments announced in 2024 and 2025 included General Motors investing $4 billion across U.S. manufacturing facilities over two years and Hyundai Motor Group committing $21 billion from 2025 to 2028.

These large-scale commitments suggest companies found sufficient returns to clear rising hurdle rates. Yet the decision calculus changed from earlier years. Equipment financing surveys show that companies now routinely underwrite deals at current interest rates rather than betting on rates declining, reflecting how elevated borrowing costs have become a permanent fixture in investment planning.

Construction spending for manufacturing facilities doubled since 2021 to reach $189.7 billion in 2024, driven particularly by computer, electronic, and electrical manufacturing, which has nearly quadrupled since 2022. This growth masks considerable selectivity: companies are funding projects with strong returns under current rate assumptions, but shelving others that might have been approved when discount rates were lower.

Beyond the metrics: practical constraints

While NPV, IRR, and payback period provide mathematical frameworks for investment decisions, companies also weigh factors the numbers alone cannot capture. Strategic priorities, competitive threats, and workforce availability influence whether projects actually receive funding. A company might reject a project with positive NPV if competing for limited capital to fund a higher-priority initiative, or accept a negative-NPV project to maintain market position.

The payback period illustrates how metrics serve different purposes. Though only 57 percent of CFOs cite it as a primary metric, it remains useful as a rough risk filter: projects that recover their cost in three years carry less execution risk than those requiring five years. In uncertain environments, particularly when interest rates remain volatile, the payback period's simplicity appeals to managers skeptical of precise NPV calculations.

As companies continue evaluating capital projects against elevated cost-of-capital thresholds, the metrics remain unchanged. But their application reflects the reality that higher interest rates have permanently shifted what investments make financial sense.

Related coverage: How business investment responds to Federal Reserve monetary policy signals; How Companies Decide What to Do With Their Cash; Why Rising Interest Rates Lower Stock Values and Bond Prices.