Companies typically evaluate the returns expected from newinvestments against a “hurdle rate” or benchmark. Investments thatearn returns in excess of the hurdle rate are expected to createvalue for shareholders and vice versa. Most companies set hurdlerates based on an analysis of their weighted average cost ofcapital (WACC). When considering investments outside their homecountry, they normally increase the hurdle rate to account for theadditional perceived risks and volatilities associated with theopportunities.

Our capital markets research shows that in faster growingemerging economies such as Brazil, India and China, investors tendto demand lower returns on capital, not higher. We measured the“required return” by quantifying the median cash-on-cash return oncapital delivered by companies valued at an enterprise value thatis equal to the gross book value, which we call the Zero NPV (netpresent value) point. This relationship on average reveals thelevel of required return set by investors as the minimum requiredto create value.

Using the above relationship, investors appear to be moresatisfied with lower levels of current return than a traditionalWACC analysis would suggest. The fast growth in emerging marketsseems to augment the perception of future value in the minds ofinvestors relative to more mature, low-growth markets.

For example, a traditional WACC analysis with country riskadjustments based on sovereign bond credit ratings and otherfactors for Brazil would have implied a hurdle rate averaging about18% from 2004 through 2007. Brazil was still recovering fromgovernment decisions that created hyperinflation over the priordecade, and rating agencies were cautious and slow to improve theirrisk assessments.

This is much higher than the required return of 11.7% implied bythe Brazilian equity capital markets over this period. Investors,ever forward looking, recognized the improving conditions and wereenticed by the rapid expected growth, so they priced it into themarket. American companies employing hurdle rates of 18% or higherwould have likely rejected many desirable value-creatinginvestments during this period.

This gap between the traditional WACC and the required returnhas narrowed for Brazil, and late in 2011 the two approachesimplied the same 10.5% hurdle rate. Despite this, many companiescontinue to apply elevated hurdle rates when evaluating investmentsin Brazil and they make similar mistakes when investing in China,India and other emerging markets as well. These companies arelikely to continue under-investing in emerging markets and willforgo the considerable revenue growth and shareholder value that isavailable from such strong growth markets.

The emerging markets of the world are growing much faster thanthe developed markets and companies that realize the value ofgrowth will ensure their strategic planning and investmentevaluation process are not biased against investing in thesecountries.

Gregory V. Milano is theco-founder and CEO and Jeffrey L. Routh, who'spictured above right, is senior associate of Fortuna Advisors,a value-based strategic advisory firm.
For more from Fortuna, see The Case for Working Capital.