What Is a Hurdle Rate?
A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. It allows companies to make important decisions on whether or not to pursue a specific project. The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk. In order to determine the rate, the following are some of the areas that must be taken into consideration: associated risks, cost of capital, and the returns of other possible investments or projects.
- A hurdle rate is the minimum rate of return required on a project or investment.
- Hurdle rates give companies insight into whether they should pursue a specific project.
- Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower risk.
- Investors use a hurdle rate in a discounted cash flow analysis to arrive at the net present value of an investment to deem its worth.
- Companies often use their weighted average cost of capital (WACC) as the hurdle rate.
Understanding a Hurdle Rate
Hurdle rates are very important in the business world, especially when it comes to future endeavors and projects. Companies determine whether they will take on capital projects based on the level of risk associated with it. If an expected rate of return is above the hurdle rate, the investment is considered sound. If the rate of return falls below the hurdle rate, the investor may choose not to move forward. A hurdle rate is also referred to as a break-even yield.
Cash flows are discounted by a set rate, which the company chooses as the minimum rate of return needed for an investment or project; the hurdle rate. The value of the discounted cash flows depends on the rate used in discounting them. The overall cost of the project is then subtracted from the sum of the discounted cash flows using the hurdle rate to arrive at the net present value of the project. If the NPV is positive, the company will approve the project. Often companies use their weighted average cost of capital (WACC) as the hurdle rate.
In the second method, the internal rate of return (IRR) on the project is calculated and compared to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely proceed.
How to Use a Hurdle Rate
Often, a risk premium is assigned to a potential investment to denote the anticipated amount of risk involved. The higher the risk, the higher the risk premium should be, as it takes into consideration the fact that if the risk of losing your money is higher, so should the return on your investment be higher. A risk premium is typically added onto the WACC to arrive at a more appropriate hurdle rate.
Using a hurdle rate to determine an investment's potential helps eliminate any bias created by preference toward a project. By assigning an appropriate risk factor, an investor can use the hurdle rate to demonstrate whether the project has financial merit regardless of any assigned intrinsic value.
For example, a company with a hurdle rate of 10% for acceptable projects would most likely accept a project if it has an IRR of 14% and no significant risk. Alternatively, discounting the future cash flows of this project by the hurdle rate of 10% would lead to a large and positive net present value, which would also lead to the project's acceptance.
Example of a Hurdle Rate
Let's take a look at a simplified example. Amy's Hammer Supply is looking to purchase a new piece of machinery. It estimates that with this new piece of machinery it can increase its sales of hammers, resulting in a return of 11% on its investment. The WACC for the firm is 5% and the risk of not selling additional hammers is low, so a low risk premium is assigned at 3%. The hurdle rate is then:
WACC (5%) + Risk premium (3%) = 8%
As the hurdle rate is 8% and the expected return on the investment is higher at 11%, purchasing the new piece of machinery would be a good investment.
Disadvantages of a Hurdle Rate
Hurdle rates typically favor projects or investments that have high rates of return on a percentage basis, even if the dollar value is smaller. For example, project A has a return of 20% and a dollar profit value of $10. Project B has a return of 10% and a dollar profit value of $20. Project A would most likely be chosen because it has a higher rate of return, even though it returns less in terms of overall dollar value.
In addition, choosing a risk premium is a difficult task as it is not a guaranteed number. A project or investment may return more or less than expected and if chosen incorrectly, this can result in a decision that is not an efficient use of funds or one that results in missed opportunities.