What is the Hurdle Rate?
Hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment which is required by the manager or investor. It is also known as the company’s required rate of return or target rate. This rate is obtained by assessing the cost of capital, risks involved, and current opportunities in business expansion, rates of return for similar investments, and other factors that have a direct effect on investment.
How to Calculate the Hurdle Rate?
In capital budgeting, this generally consists of two major elements. They are as follows:
- The first element is the company’s cost of capital or fund, which is the Weighted Average Cost of Capital (WACC).
- The second element is the risk premium formula, which entirely is dependent on the riskiness of the particular project.
The formula used in capital budgeting is
Hurdle Rate formula = Weighted Average Cost of Capital (WACC)+ Risk Premium (the risk to be accounted which is associated with the project’s cash flows)
Let us suppose that the cost of capital for XYZ Ltd. is 8% per year when they are evaluating the projects which they wish to invest in. Managers working at XYZ Ltd. will add up a risk premium of supposing 5% per year for those projects which have more uncertain cash flows but only adding 0.5% for those projects which are less risky and have predictable cash flows.
So we can calculate Hurdle Rate as 8%+ 5%= 13% per year for the projects which are risky and have uncertain cash flows, whereas, for less risky projects with certain cash flows, it is = 8%+ 0.5%= 8.5% per year.
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The managers at XYZ Ltd. add up risk premium to the cost of capital or the Weighted Average Cost of Capital (WACC) for determining the hurdle rate. They want to make a clear comparison between the projects and decide which projects are good for investment and those not suitable for investment.
It may happen that a low-risk project may not look very much appealing on the paper because of smaller potential cash flows, but because of this, it cannot be termed as an unworthy selection. Just because of this, the managers, after adding up the risk premium in the equation, can find that the low-risk project may yield a higher Net Present Value (NPV), which makes it worthy of investment.
Breaking Down Hurdle Rate
Hurdle Rate acts as a benchmark for comparison between the worthiness of a particular investment and associated risk.
- In capital budgeting, if the expected rate of return is higher than the hurdle rate, then the investment is considered to be a good one. If the rate of return is lower, then the investor may choose not to go ahead with the investment. It is also termed as a break-even yield. The minimum hurdle rate is generally the company’s cost of capital. But in cases of projects with higher risk and an abundance of investment opportunities, the rate increases.
- For hedge funds, the hurdle rate is the rate of return that the fund manager has to beat before collecting incentive fees.
- While doing the Net Present Value (NPV) analysis, the hurdle rate is the rate that is used to discount future net cash flows of the project. This rate is often adjusted up and down depending on the perceived riskiness of the project.
Key Factors to Determine Hurdle Rate
Before investing in any project, a company must first decide to do a preliminary evaluation to determine whether the project has a positive net present value (NPV). It should always be kept in the mind that setting a very high rate can hinder other profitable projects. Again setting a low, the rate can also end up in an unprofitable project. While determining the hurdle rate, the factors that are to be considered are as follows:
- A risk value should be assigned for the expected risk involved with the project. Projects with high risk usually have greater these rates compared to the less risky ones.
- The inflation rate is another crucial factor. If the economy is undergoing mild inflation, then it may influence the final rate by 1-2%. There can be situations when inflation plays a critical determining factor in setting this rate.
- It always needs to be compared to real investment rates because interest rates reflect the opportunity cost earned on another investment.
- It can be biased towards investments that give high rates of return, even if the Net Present Value (NPV) is very small.
- It may end up rejecting huge dollar value projects which can generate more cash for the investors but with a lower rate of return.
- The cost of capital is generally considered based on this rate, and this concept may change with time.
For achieving long-term profitability and a good investment level, the most important thing is to determine a reliable rate. There are situations when the legal requirement is essential for the completion of the project, where this rate is considered to be a non-factor. With less importance to risks or expected returns, the crucial projects move ahead to comply with applicable laws and regulations.
This article has been a guide to what Hurdle Rate is. Here we discuss how to calculate hurdle rate using its formula along with practical examples, its key factors, limitations, etc. You may learn more about excel modeling from the following articles –