Entrepreneurial Miscalculation and Business Cycles: How Interest Rate Targeting Distorts Capital Budgeting

Abstract

This article, using Austrian Business Cycle Theory, shows how entrepreneurs and business managers are vulnerable to central bank monetary policies targeting interest rates. These policies distort market signals used as inputs in widely used capital budgeting metrics. Their reliance on nominal cash flows—together with their dependence on market-based discount rates, themselves directly or indirectly influenced by central bank policy—induces entrepreneurs to misestimate the real future profitability and feasibility of investment projects. Based on distorted market signals, entrepreneurs and business managers ignite an unsustainable economic boom. The divergence between ex ante and ex post profitable investment projects is widened because of business miscalculation leading to a cluster of errors that eventually results in the bursting of an economic boom. Therefore, although the exogenous distortion of market signals is a necessary condition of a business cycle, its ignition is purely endogenous.

Keywords:

• business cycle
• capital budgeting
• central bank
• discounting
• interest rate

JEL Codes:

• B53
• E32
• E40
• E58
• G21

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹Where k_ex stands for external equity capital, k_ei for internal equity capital, k_d for debt, while r_ex stands for cost of external equity, r_ei for cost of internal equity (usually an opportunity cost), and r_d for cost of debt. For simplicity's sake, the WACC is not detailed for the different kinds of external equity (for example, ordinary and preferred stock, classified shares) and debt (for example, bonds, negotiable instruments) that an enterprise can issue.

²Although not all enterprises actually use formal capital budgeting techniques to evaluate investment opportunities, it is plausible to assume that, generally, investment evaluation can be described by those techniques. In fact, those techniques consist in more refined profit and loss calculations accounting for the cost of time calculations and a cost that even informal entrepreneurs pay attention to. The investment decision criteria implied by these techniques and involving the WACC are: Net Present Value (NPV, Equation 2), choose the highest positive NPV among all alternatives; Discounted Payback Period (DPP, Equation 3), choose the project that more rapidly recovers investment cash flows relative to a target period; Internal Rate of Return (IRR, Equation 4) and Modified Internal Rate of Return (MIRR, Equation 5), if (M)IRR > WACC, then choose the project with the highest (M)IRR among all eligible alternatives; Profitability Index (PI, Equation 6), choose the project with the highest PI among all alternatives.

³This has been pointed out in the Austrian literature by Cwik (2008) and Machlup (1935). If the present value of working capital is given by , where P_factors is the price of the factors of production, and r is the required return on debt, then, the percentage change in the present value of working capital is: . In this manner, a rise in the interest rate of 50 per cent on a working capital with a turnover rate of 4, from say 2 to 3 per cent, only has an impact of 0.248 per cent on the cost of financing working capital.

⁴For more on the trade-off theory of capital structure, see Kraus and Litzenberger (1973), and Miller (1977). On the market timing approach, see Baker and Wurgler (2002), and Welch (2002, 2004). On the pecking order of capital structure, see Myers (1984) and Shyam-sunder and Myers (1999).

⁵See Cantillon (1997) for a recent edition of Cantillon's Essai sur la nature du commerce en general.