What Exactly Is a Hurdle Rate?
A hurdle rate is the minimum rate of return required by a manager or investor on a project or investment. It enables businesses to make critical decisions about whether or not to pursue a specific project. The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects have higher hurdle rates than less risky projects.
The following factors must be considered when determining the rate: associated risks, cost of capital, and the returns of other possible investments or projects.
KEY TAKEAWAYS
- A hurdle rate is the required minimum rate of return on a project or investment.
- Companies can use hurdle rates to determine whether or not to pursue a specific project.
- Higher hurdle rates are associated with riskier projects, while lower rates are associated with lower risk.
- In a discounted cash flow analysis, investors use a hurdle rate to determine the net present value of an investment.
- As a hurdle rate, companies frequently use their weighted average cost of capital (WACC).
Understanding Hurdle Rates
In the business world, hurdle rates are extremely important, especially when it comes to future endeavors and projects. Companies decide whether or not to undertake a capital project based on the level of risk involved. The investment is considered sound if the expected rate of return exceeds the hurdle rate. If the rate of return falls below the threshold, the investor may decide not to proceed. A break-even yield is another term for a hurdle rate.
There are two methods for determining a project’s viability. First, a company makes a decision using the net present value (NPV) method, which involves performing a discounted cash flow (DCF) analysis.
Cash flows are discounted at a fixed rate determined by the company as the minimum rate of return required for an investment or project: the hurdle rate. The value of the discounted cash flows is determined by the discount rate used. The net present value of the project is calculated by subtracting the total cost of the project from the sum of the discounted cash flows using the hurdle rate. If the NPV is positive, the project will be approved. Companies frequently use their weighted average cost of capital.
The internal rate of return (IRR) on the project is calculated and compared to the hurdle rate in the second method. If the IRR exceeds the hurdle rate, the project will almost certainly move forward.
Usage of the Hurdle Rate
A risk premium is frequently assigned to a potential investment to indicate the amount of risk involved. The higher the risk, the higher the risk premium, because it considers that if the risk of losing your money is higher, so should the return on your investment. To arrive at a more appropriate hurdle rate, a risk premium is typically added to the WACC.
Using a hurdle rate to determine the potential of an investment helps to eliminate any bias caused by a preference for a project. An investor can use the hurdle rate to demonstrate whether the project has financial merit regardless of any assigned intrinsic value by assigning an appropriate risk factor.
A company with a 10% hurdle rate for acceptable projects, for example, would most likely accept a project with an IRR of 14% and no significant risk. Alternatively, discounting the project’s future cash flows by the 10% hurdle rate would result in a large and positive net present value, leading to project acceptance.
Example of a Hurdle Rate
Consider the following simplified example. Amy’s Hammer Supply is looking to purchase new equipment. It expects to increase hammer sales with this new piece of equipment, resulting in an 11% return on investment. The firm’s WACC is 5%, and the risk of not selling additional hammers is low, so a low risk premium of 3% is assigned. The following is the hurdle rate:
WACC (5%) + Risk premium (3%) = 8%
Purchasing new machinery would be a good investment because the hurdle rate is 8% and the expected return on investment is 11%.
Disadvantages of a Hurdle Rate
Hurdle rates typically favor projects or investments with high percentage rates of return, even if the dollar value is small. Project A, for example, has a 20% return and a $10 profit value. Project B has a 10% return and a profit value of $20. Project A is most likely chosen because it has a higher rate of return, despite returning less in terms of total dollar value.
Furthermore, selecting a risk premium is difficult because it is not a fixed number. A project or investment may yield more or less than expected, and if chosen incorrectly, this can result in a decision that is inefficient or results in missed opportunities.
Why Is Hurdle Rate Important?
A hurdle rate, also known as a break-even yield, is critical in business, particularly when it comes to future endeavors and projects. Companies decide whether or not to undertake capital projects based on the level of risk involved. The investment is considered sound if the expected rate of return exceeds the hurdle rate. If the rate of return falls below the threshold, the investor may decide not to proceed.
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