﻿ Hurdle rate: What is it, Usage, Disadvantages , Example, FAQ

# 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.

## Category

### Read the Latest Market Journal

#### Back in Business: The Return of IPOs & Top Traded Counters in March 2024

Published on Apr 17, 2024 404

Start trading on POEMS! Open a free account here! At a glance: Major indices continue...

#### Weekly Updates 15/4/24 – 19/4/24

Published on Apr 15, 2024 67

This weekly update is designed to help you stay informed and relate economic and company...

#### From \$50 to \$100: Unveiling the Impact of Inflation

Published on Apr 12, 2024 150

In recent years, inflation has become a hot topic, evoking strong emotions as the cost...

#### Japan’s Economic Resurgence: Unveiling the Tailwinds Behind Nikkei 225’s Record Leap

Published on Apr 11, 2024 84

Source: eSignal, Intercontinental Exchange, Inc. In the heart of Japan’s economic landscape, the Nikkei 225...

#### Weekly Updates 8/4/24 – 12/4/24

Published on Apr 8, 2024 109

This weekly update is designed to help you stay informed and relate economic and...

#### What Makes Forex Trading Attractive?

Published on Apr 2, 2024 191

In a world where the click of a button can send goods across oceans and...

#### Weekly Updates 1/4/24 – 5/4/24

Published on Apr 1, 2024 98

This weekly update is designed to help you stay informed and relate economic and company...

#### How to soar higher with Positive Carry!

Published on Mar 28, 2024 137

As US Fed interest rates are predicted to rise 6 times this year, it’s best...

POEMS 3 App

• Call Back

• Chat with us

## Contact us to Open an Account

Need Assistance? Share your Details and we’ll get back to you

IMPORTANT INFORMATION

This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.

An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.

Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.

Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.

The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <www.phillipfunds.com> for more information in relation to the dividend distributions.

The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.

The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published.

This advertisement has not been reviewed by the Monetary Authority of Singapore.

Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)
250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101
Tel: (65) 6230 8133 Fax: (65) 65383066 www.phillipfunds.com