Hurdle rate

Hurdle rate

Evaluating the possible risks and benefits is a smart idea before investing in a business or project. The hurdle rate is one strategy for doing this. You may use this investing tool to estimate the anticipated rate of return necessary for an investment to be risk-acceptable. 

What is a hurdle rate? 

The hurdle rate is the minimum or least acceptable rate of return on a project or investment. In other words, it is the required rate of return that a company must earn on investment to justify the investment. This is sometimes referred to as the minimum acceptable rate of return, the target rate or the required rate of return. It is expressed in percentage form. 

Understanding hurdle rates 

A corporation must anticipate a rate of return that meets or surpasses the hurdle rate before moving forward with an investment. An investment with returns below the threshold is often viewed as either too hazardous to be justified or, in some situations, less profitable than other options. 

A business may develop a basic rate of return that it needs from feasible initiatives to define its hurdle rate institutionally. Alternatively, it may employ a project-specific hurdle rate to evaluate each project in light of the present situation. 

Check the project’s net present value before investing to check if it is positive (NPV). A discounted cash flow evaluation must be conducted in this situation. If the NPV is positive, the estimated rate of return for the project surpasses the hurdle rate. However, the investment may not be worthwhile given the risk if it’s a negative figure. 

The  WACC, or weighted average cost of capital, is another necessary component. A company’s equity and debt are both measured in this way. 

Usage of the hurdle rate 

The hurdle rate is used to evaluate investment opportunities and to make decisions about whether or not to proceed with a particular investment. If the expected return on investment is less than the hurdle rate, the investment is not worth pursuing. On the other hand, if the expected return on investment is greater than the hurdle rate, the investment is worth pursuing.  

 Suppose a company has a hurdle rate of 10% for approved projects and approves a project with an IRR of 14% and minimal risk. So, a substantial and positive NPV or net present value would result from discounting the project’s future cash flows by the hurdle rate of 10%, which would also result in the project’s approval. 

Example for hurdle rate 

Let’s imagine that Ryan’s Food Factory wishes to determine whether investing in a new machine is a wise decision in order to demonstrate how the hurdle rate works. It predicts that acquiring it might raise sales by 20%. The risk premium is 3%, while the WACC is 12%. 

 

The hurdle rate would be = WACC + risk premium  

                                         = 12% + 3% 

                                         = 15% 

        

Thus the new machine could be a suitable investment because the expected return on investment (20%) is higher than the hurdle rate (15%). 

Disadvantages of a hurdle rate 

A few potential disadvantages exist to set a hurdle rate for capital investment projects.  

  • It can lead to sub-optimal decision-making if the rate is set too high. For example, if the hurdle rate is 10% and a project with a 9% return is rejected, but a project with an 8% return is accepted, this could lead to a sub-optimal outcome.  
  • The hurdle rate can create a bias against new and innovative projects since these often have higher risks and lower expected returns. This can lead to stagnating new ideas and a lack of innovation within the company.  
  • The hurdle rate can be difficult to set accurately since it depends on several factors, such as the company’s risk tolerance, the market conditions, and the specific project being considered. 
  • Furthermore, picking a risk premium is challenging since the value is uncertain. If chosen wrong, an investment or project may yield a higher or lower return than anticipated, leading to inefficient use of resources or the passing of chances. 

 

Frequently Asked Questions

The hurdle rate is important because it is used to evaluate investment opportunities and to make decisions about whether or not to proceed with a particular investment.  

When determining the hurdle rate, an investor begins with the cost of capital, the minimum rate of return the company must earn on its investments to satisfy its shareholders. Then, the risk premium is added to account for the probability that the investment will fail.  

The cost of capital is the minimum return shareholders expect from investing in the company. It is important to consider that the cost of capital is not the same as the hurdle rate. The cost of capital is the required rate of return on investment, while the hurdle rate is the minimum acceptable rate of return.  

 

The following key factors that must be taken into account in order to calculate the hurdle rate are: 

  • cost of capital 
  • return from similar investments 
  • associated risks 
  • anything else that may affect the investment 

The hurdle rate is often higher, the riskier the investment is. To determine the hurdle rate, an investor adds the risk premium required to account for the probability that the investment would fail to the cost of capital.  

 The equation for hurdle rate is the cost of capital + risk premium. 

In the business world, hurdle rates play a crucial role, particularly in future projects and initiatives. The degree of risk involved in a project influences whether or not a company decides to take it on. The investment is deemed sound if the predicted rate of return exceeds the hurdle rate. In other words, the investor may choose to proceed with an investment if it promises to offer a return that is equal to or greater than the hurdle rate. 

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