The rental rate of capital is what it actually costs a business to own and use a piece of equipment or property for a period of time, expressed as a single number that combines financing costs, depreciation, and any change in the asset’s market value. Economist Dale Jorgenson formalized the concept in the 1960s, and it remains the standard way to answer a basic question: does owning this asset earn back what it ties up?1National Bureau of Economic Research. The Theory of Investment Behavior The sticker price of a machine tells you almost nothing on its own. Two assets with identical price tags can carry very different rental rates depending on how fast they lose value, what interest rates look like, and where the resale market is heading.
The Formula
In the notation most textbooks use:
Rental Rate = P × (r + δ) − ΔP
P is the purchase price of the asset. r is the real interest rate, meaning the financing cost after stripping out inflation. δ (delta) is the rate of depreciation. ΔP is the change in the asset’s price over the period.
The first part captures what the owner gives up by holding the asset instead of putting that money somewhere else, plus the value the asset sheds through wear and aging. The second part subtracts appreciation, because a rising resale price offsets some of the ownership cost. If a tractor’s market price climbs during the year, the net burden of owning it drops. If the tractor loses resale value on top of ordinary depreciation, the rental rate climbs.
What Depreciation Actually Covers
The delta term is doing more work than it looks. In practice, at least three distinct forces pull down an asset’s value, and each one responds to different management decisions.
- Physical depreciation is normal wear and tear from use, exposure, and aging. A delivery truck loses value with every mile. Maintenance slows it; nothing stops it.
- Functional obsolescence is loss of value tied to the asset’s own design limits compared with newer alternatives. A 2015 CNC machine may still run, but if a 2025 model produces twice the output at lower energy cost, the older one is worth less regardless of its physical condition.
- Economic obsolescence is loss of value from forces outside the asset. A drop in demand for the product it makes, a shift in raw material availability, or new regulations restricting its use can slash worth overnight.
Physical depreciation is the most predictable of the three and the easiest to model with standard schedules. The other two hit irregularly and can accelerate the effective depreciation rate well beyond what historical patterns suggest. A firm that plugs only physical wear into its rental rate calculation and ignores obsolescence risk will overvalue its capital stock. That mistake is especially common in technology-heavy industries with short product cycles.
Pinning Down the Interest Rate
The r variable represents the real cost of the funds tied up in the asset. In a textbook, that’s a single number. In a real business, estimating it means looking at the whole financing structure.
Most firms use their weighted average cost of capital (WACC) as the practical stand-in for r. WACC blends the cost of equity (what shareholders expect to earn) with the after-tax cost of debt (what lenders charge, discounted by the tax benefit of deducting interest), weighted by how much of each the company uses. A firm funded 60% by equity expecting a 10% return and 40% by debt at 5% after tax has a WACC around 8%. That 8% is the financing cost baked into every rental rate calculation the firm runs.
Real interest rates move with monetary policy, inflation expectations, and credit conditions. When central banks tighten and borrowing costs rise, WACC rises with them, pushing rental rates higher across the economy. That is the mechanism through which higher interest rates slow business investment.
What the Number Is For
The rental rate only becomes useful when compared with what the capital actually produces. The extra output generated by one additional unit of equipment is the marginal product of capital (MPK). In a competitive market, a profit-maximizing firm keeps adding capital until the revenue from the last unit exactly equals the rental rate.2National Bureau of Economic Research. The Marginal Product of Capital
If MPK exceeds the rental rate, every additional dollar of equipment earns more than it costs, and the firm should invest more. If the rental rate exceeds MPK, the last unit of capital is a net loss, and the firm should scale back. Equilibrium sits where the two are equal.
This is the core insight of the framework. It explains why investment booms during periods of cheap credit, when low r pulls down the rental rate and makes more projects profitable, and why investment collapses when interest rates spike or depreciation accelerates. It also explains why two firms in the same industry can rationally make opposite investment decisions: their marginal products differ because of workforce skill, technology adoption, or capacity utilization.
Hurdle Rates in Practice
Most companies do not sit down with the Jorgenson formula before buying a forklift. They use a hurdle rate: the minimum expected return a project must clear before management approves it. The hurdle rate starts with WACC and then adds a risk premium for uncertainty about cash flows, industry volatility, or strategic priorities.
If a firm’s WACC is 8% and it adds a 4% risk premium, no project earning less than 12% gets funded. The hurdle rate is the rental rate concept translated into corporate finance language. When firms raise their hurdle rates during uncertain times, they are implicitly raising the rental rate they demand from every piece of equipment, which cuts investment even without any change in interest rates or depreciation schedules.
What Moves the Rate
Each variable in the formula responds to forces outside any single firm’s control. Inflation is the most pervasive. Rising general prices push up nominal interest rates, increase the replacement cost of equipment, and can either raise or lower the ΔP term depending on whether the specific asset’s price rises faster or slower than the overall price level.
Supply conditions in capital goods markets matter too. A semiconductor shortage that doubles the price of industrial controllers raises P and immediately increases the rental rate for any business that needs the equipment. An oversupply of used construction equipment after a building bust lowers P and can make capital temporarily cheap.
Replacement Cost Versus Historical Cost
One subtle question trips up many rental rate calculations. Which price do you use for P? The price you originally paid, or what it would cost to buy the same asset today? During low inflation the difference is trivial. During high inflation it can be enormous.
A factory purchased for $2 million in 2018 that would cost $3.5 million to replace today has a much higher true rental rate than the historical-cost calculation suggests. Using the old price understates the real economic cost of tying up that capital, because if you sold the factory you could collect close to $3.5 million. The Bureau of Economic Analysis tracks both measures for the U.S. economy, and the gap between them widens whenever asset price inflation exceeds a threshold that depends on the average age and depreciation rate of the capital stock.
How Tax Law Lowers the After-Tax Rental Rate
Tax law is where the rental rate moves from textbook theory to real money. Every dollar the tax code lets a business deduct, expense, or credit against the cost of equipment effectively lowers the after-tax rental rate.
MACRS and Accelerated Depreciation
Federal law lets businesses deduct the cost of property used in a trade or business over time through annual depreciation allowances.3Office of the Law Revision Counsel. 26 U.S. Code 167 – Depreciation The Modified Accelerated Cost Recovery System (MACRS) assigns each type of asset a recovery period and front-loads deductions so businesses write off more of the cost in early years.4Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System A machine with a seven-year recovery period doesn’t lose exactly one-seventh of its deductible value each year. The 200% declining balance method concentrates deductions early, then switches to straight-line when that produces a larger write-off.
A dollar of tax savings today is worth more than a dollar of savings five years from now. Front-loading deductions reduces the present value of the after-tax rental rate, making investment cheaper in real terms even though the total deduction over the asset’s life stays the same.
Section 179 and Bonus Depreciation
Two provisions go further by letting businesses deduct the full cost of qualifying assets in the year they are placed in service.
Section 179 allows a business to expense up to $2,500,000 of qualifying property in a single year, with a phase-out that begins when total qualifying purchases exceed $4,000,000.5Office of the Law Revision Counsel. 26 USC 179 – Election to Expense Certain Depreciable Business Assets Both thresholds adjust annually for inflation starting in 2026. Section 179 caps the deduction at the business’s taxable income for the year, so a company without sufficient income cannot generate a loss from the deduction alone.
Bonus depreciation under Section 168(k) works alongside or instead of Section 179. Following the passage of the One Big Beautiful Bill Act in mid-2025, bonus depreciation was permanently set at 100% for qualifying tangible property with a recovery period of 20 years or less, computer software, and qualified improvement property placed in service after January 19, 2025.4Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System Unlike Section 179, bonus depreciation has no annual dollar cap and is not limited to taxable income, so it can generate or increase a net operating loss.
The practical effect is large. Full immediate expensing can reduce the after-tax rental rate of a capital asset by 20% or more depending on the firm’s marginal tax rate, because the entire tax benefit arrives in year one instead of trickling in over five, seven, or fifteen years.
Clean Energy Investment Credits
Investment tax credits work through a different mechanism. Instead of lowering taxable income, they reduce the tax bill dollar for dollar. The clean electricity investment credit under Section 48E offers a base credit of 6% of qualified investment, rising to 30% for projects that meet prevailing wage and apprenticeship requirements.6Office of the Law Revision Counsel. 26 USC 48E – Clean Electricity Investment Credit Projects using domestically manufactured components or located in designated energy communities can stack additional bonuses of up to 10 percentage points each.
A 30% investment credit on a $10 million solar installation means $3 million directly off the tax bill, equivalent to cutting P in the Jorgenson formula by nearly a third. Credits are the main reason renewable energy projects often show lower effective rental rates than conventional alternatives with similar output.
What Raises the After-Tax Rate Back Up
Depreciation Recapture on Sale
Every depreciation deduction that lowered the rental rate during ownership creates a potential tax hit at sale. When you sell a capital asset for more than its depreciated book value, the IRS recaptures some or all of the earlier tax benefit.
For equipment and machinery (Section 1245 property), the entire gain up to the amount of depreciation previously taken is taxed as ordinary income, not at the lower capital gains rate.7Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property If you bought a $500,000 machine, claimed $300,000 in depreciation deductions, and later sold it for $400,000, the $200,000 gain (sale price minus the $200,000 adjusted basis) is ordinary income. For buildings and other real property under Section 1250, the rules are gentler: gain attributable to straight-line depreciation faces a maximum rate of 25%, and any gain above total depreciation taken is taxed at long-term capital gains rates.
Recapture does not eliminate the benefit of accelerated depreciation or immediate expensing. The time value of money still works in the owner’s favor, and the recapture tax is deferred until sale. But it means the true after-tax rental rate over the asset’s full lifecycle is higher than a calculation that ignores the eventual sale would suggest. Firms that flip equipment frequently feel this more than those that run assets until they are worthless.
The Business Interest Deduction Cap
For larger businesses, the tax benefit of debt financing, which lowers WACC and therefore the rental rate, is itself capped. Section 163(j) limits the deduction for business interest expense to the sum of business interest income plus 30% of adjusted taxable income.8Office of the Law Revision Counsel. 26 USC 163 – Interest Any interest above that ceiling cannot be deducted in the current year, though it carries forward.
Small businesses are exempt if their average annual gross receipts over the prior three years do not exceed the gross receipts test threshold, which for 2026 is $32,000,000.9Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Above that line, the limit raises the effective after-tax cost of debt, which raises WACC, which raises the rental rate of every capital asset. Highly leveraged firms in real estate, utilities, and manufacturing feel this most acutely.
There’s a planning tension here worth naming. A firm that takes 100% bonus depreciation generates large deductions that shrink taxable income, which shrinks the 30% adjusted-taxable-income base for the interest cap, which may limit how much interest the firm can deduct. Aggressive use of one provision can inadvertently trigger a limitation on the other. Getting the sequencing right is one of the more consequential capital planning decisions a CFO makes.