Finance

Rethinking Capital Allocation in a Higher-Rate Environment

Higher rates have permanently changed the calculus of capital deployment — firms still using pre-2022 hurdle rates are systematically misallocating resources.

Laura Prescott · January 20, 2026 · 3 min read

The Hurdle Rate Problem

The decade of near-zero interest rates that preceded 2022 created a generation of capital allocation frameworks built around a cost of capital that no longer exists. Hurdle rates that were set in a low-rate environment systematically understate the true cost of capital in the current environment, and organisations that have not updated them are approving investments that would not pass a rigorous cost-of-capital test.

The consequences are not immediately visible — a project approved at a hurdle rate that is too low will not obviously underperform in its early years. But the cumulative effect of systematically misallocating capital over several years is a portfolio of investments that is generating returns below the cost of capital, eroding shareholder value in ways that are difficult to attribute to any single decision.

Updating the Framework

Updating a capital allocation framework is straightforward in principle and politically difficult in practice. The technical work — recalculating the weighted average cost of capital, updating hurdle rates, and re-evaluating the existing investment portfolio against the new rates — is not complicated. The difficult part is the organisational conversation that follows: some investments that were approved under the old framework will not pass the new one, and some business units that were generating acceptable returns in a low-rate environment will not be generating acceptable returns in the current one.

The organisations that have managed this conversation most effectively are those that have framed the framework update as a response to a changed environment rather than as a judgment on past decisions. The investments that were approved under the old framework were not necessarily wrong — they were made with the information available at the time. The question is what to do with them now, given that the environment has changed.

Portfolio Rationalisation

A rigorous capital allocation framework in a higher-rate environment will typically identify a set of investments and business units that are not generating returns above the cost of capital. The appropriate response is portfolio rationalisation — exiting those investments and redeploying the capital to higher-return opportunities. This is a discipline that most organisations find difficult, because the businesses and investments that are underperforming are typically ones that have internal advocates and historical significance.

The organisations that have executed portfolio rationalisation most effectively are those that have made it a systematic process rather than a crisis response. Regular portfolio reviews that evaluate each business and investment against the current cost of capital, with clear criteria for what triggers an exit decision, are more effective than ad hoc reviews triggered by financial distress.

The Opportunity in Discipline

The higher-rate environment is not only a constraint — it is also an opportunity for organisations that have the discipline to maintain rigorous capital allocation standards. In an environment where many organisations are misallocating capital, the organisations that are allocating it well will generate superior returns and will have the financial capacity to invest in the opportunities that their less disciplined competitors cannot afford to pursue.

The organisations that will emerge from the current environment in the strongest competitive position are those that have used the higher-rate period to build the capital allocation discipline that the low-rate era allowed them to avoid. That discipline — clear hurdle rates, rigorous portfolio reviews, and the willingness to exit underperforming investments — is not just a response to the current environment. It is the foundation of sustained value creation in any environment.

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