Corporate finance IT DID raise some eyebrows at first. Two months ago, when Aegon, a Dutch life insurer known for taking care of its shareholders, bought Transamerica, a San Francisco-based insurer, Aegon said it was expecting a return of only 9% from the deal, well below the 11% ?hurdle rate? it once proclaimed as its benchmark. Had this darling of the stockmarket betrayed its devoted investors for the sake of an eye-catching deal?

Not at all. Years of falling interest rates and rising equity valuations have shrunk the cost of capital for firms such as Aegon. So companies that regularly adjust the hurdle rates they use to evaluate potential investment projects and acquisitions are not cheating their shareholders. Far from it: they are doing their investors a service. Unfortunately, such firms are rare in Europe. ?I don?t know many companies at all who lowered their hurdle rates in line with interest rates, so they?re all underinvesting,? says Greg Milano, a partner at Stern Stewart, a consultancy that helps companies estimate their cost of capital.

This has a huge impact on corporate strategy. Companies generally make their investment decisions by discounting the net cash-flows a project is estimated to generate to their present value. If that net present value is positive, the project should, in theory, make shareholders better off. But the entire decision rests on the accuracy of both the cash-flow forecasts and the discount rate. Set the rate even a sliver too high, and good projects appear bad; set it too low and bad investments look appealing.

This makes it all the more surprising that some companies pay little attention to the impact on the discount rate of changes in their cost of capital. Steve Hodge, treasurer of Shell, an Anglo-Dutch oil giant, says that a difference of only one percentage point in the discount rate can change the value of, say, an oil refinery with a 15-year life by hundreds of millions of dollars. Nonetheless, Shell left its hurdle rates unchanged for two decades until it ?nudged them down? in 1997, and now intends to keep them at present levels for years to come.

Generally speaking, says Paul Gibbs, an analyst at J.P. Morgan, an American bank, finance directors in America often review their hurdle rates; in continental Europe they do so sometimes, and in Britain, rarely. As a result, the Confederation of British Industry, a big-business lobby, worries about underinvestment, and officials at the Bank of England grumble about firms? reluctance to lower hurdles.

This reluctance seems surprising, since companies with high hurdle-rates will tend to lose out in bidding for business assets or firms?as, according to Mr Hodge, Shell has often done. In a deal-crazy environment such as America?s, reckons Rick Escherich of J.P.Morgan, the fear of missing out on a spectacular merger wave has encouraged managers to keep their hurdle rates as low as possible. On average they are now down to about 10% from 12% a few years ago.

But many managers remain deeply sceptical about the theory behind discount rates. Even though it spits out percentages to several decimal points, the capital-asset pricing model, as the conceptual framework for calculating the rates is called, is controversial in itself. ?The whole basis of setting hurdle rates is flawed,? says Mr Hodge. ?If you change the hurdle rate you?re hiding away a management decision in a piece of spurious arithmetic.?

Spurious or not, that arithmetic should reflect not only interest rates but also the riskiness of each individual project. For instance, Siemens, a German industrial giant, last year started assigning a different hurdle rate to each of its 16 businesses, ranging from household appliances to medical equipment and semiconductors. The hurdle rates?from 8% to 11%?are based on the volatility of shares in rival companies in the relevant industry, and are under constant review.

As scientific as it sounds, however, this approach is not foolproof. ?You find two companies in the same industry, who should be using similar rates, but one uses 10%, the other 30%. One or both must be wrong,? says Mr Milano. That is what brings the managers? decision out of hiding.