Hurdle Rate

The hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment the manager requires the manager or investor requires. It is also known as the company’s required rate of return or target rate. The most important thing to achieve long-term profitability and a good investment level is to determine a reliable rate.

This rate is obtained by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors that have a direct effect on investment. There are situations when the legal requirement is essential for the completion of the project, where a hurdle rate equation is considered a non-factor.

The term hurdle rate is a fundamental concept in finance, often used by investors and companies to evaluate the attractiveness of potential investments or projects. Essentially, it serves as a benchmark or minimum rate of return that an investment must surpass in order to be considered worthwhile.

Imagine you're a savvy investor looking at various opportunities to grow your wealth. The hurdle rate is like a personal financial benchmark. Given the risks involved, it represents the return you demand to justify taking on a particular investment.

In a corporate context, companies use the finance hurdle rate to assess the feasibility of new ventures or projects. It helps them determine whether the potential returns outweigh the costs and risks. If an investment doesn't promise returns above the hurdle rate, it's usually deemed too risky or not financially sound.

Calculating the hurdle rate can be a bit complex. It typically considers factors like the company's cost of capital, the risk associated with the investment, and the expected return from alternative investments.

Therefore, the hurdle rate is a critical finance decision-making tool. It ensures that investments meet a predetermined standard, helping individuals and businesses make informed choices about allocating their money for maximum financial benefit.

Let us understand the formula to form a hurdle rate equation through the explanation below. This formula shall act as our basis of understanding of this concept and its related factors.

Hurdle Rate formula = + " url="https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/"]Weighted Average Cost of Capital (WACC)+ Risk Premium (the risk to be accounted which is associated with the project’s cash flows)

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 = + " url="https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/"]Weighted Average Cost of Capital (WACC)+ Risk Premium (the risk to be accounted which is associated with the project’s cash flows)

Now that we have understood the basics, formula, and how to calculate finance hurdle rate, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

Let us suppose that the cost of capital for XYZ Ltd. is 8% per year when they are evaluating the projects in which they wish to invest. Managers working at XYZ Ltd. will add up a risk premium of supposing 5% per year for those projects that have more uncertain cash flows but only adding 0.5% for those projects that are less risky and have predictable cash flows.

Hence, we can calculate the Hurdle Rate as 8%+ 5%= 13% per year for the projects that 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.

The managers at XYZ Ltd. add 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 appealing on paper because of smaller potential cash flows. Still, 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.

Example #2

Next, the British multinational clothing, footwear, and home products retailer revealed a rather interesting take on setting marketing budgets. Their CEO, Lord Wolfson, said that Next’s marketing team looks at hurdle rate as one of its primary metrics to set the marketing budget.

For every pound spent on marketing, they aim to earn a pound and a half in return. If the team does not pass this benchmark, the marketing budget will be cut back in the next accounting period.

This announcement came right after the company decided to increase its marketing budget by 55% to explore its presence in regions that it previously did not capitalize on.

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.

The hurdle rate equation 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. However, 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.

Let us also shed some light on the limitations of finance hurdle rates through the points below.

• 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.

While both the hurdle rate and IRR are crucial in investment decision-making, there are differences in their fundamentals and implications. Let us understand them through the comparison below.

Hurdle Rate

• The hurdle rate, also known as the minimum acceptable rate of return, is a predetermined benchmark or threshold that a company or investor sets to evaluate the attractiveness of an investment.
• It represents the minimum return an investment must generate to justify the associated risks and costs.
• Hurdle rates are typically fixed percentages or rates based on the company's cost of capital and risk tolerance.
• It helps in screening and prioritizing investment opportunities; only those projects or investments exceeding the hurdle rate are considered viable.

Internal Rate of Return (IRR)

• IRR is a financial metric used to assess the potential profitability of an investment.
• It calculates the discount rate at which the net present value (NPV) of future cash flows from an investment becomes zero.
• Unlike the hurdle rate, which is a predetermined benchmark, IRR is a result of the investment analysis.
• To decide on an investment, a project's IRR should ideally exceed the company's or investor's hurdle rate. If the IRR is higher than the hurdle rate, the project is considered viable; otherwise, it's rejected.

This article has been a guide to Hurdle Rate definition. Here we explain its formula, how to calculate, examples, and importance, and we compare it with IRR. You may learn more about excel modeling from the following articles -

• Calculate the Required Rate of Return
• Carried Interest in Private Equity
• Cost-Benefit Analysis Steps
• Internal Rate of Return Calculation