A hurdle rate is the lowest rate of return a project or investment must achieve before a manager or investor deems it acceptable. It’s critical for companies or investors when making crucial decisions like pursuing a specific project. Riskier projects typically have higher hurdle rates than those with less risk.
Key Takeaways
- A hurdle rate is the minimum rate of return required on a project or investment.
- It provides clarity on whether pursuing a project is worthwhile.
- The higher the risk, the higher the hurdle rate.
- Investors use a hurdle rate in a discounted cash flow analysis to determine an investment’s value and assess its worth.
- Companies sometimes use their weighted average cost of capital (WACC) as the hurdle rate.
- Private equity and hedge funds use a hurdle rate to determine when general partners (GPs) are entitled to performance fees.
The term is also often used in private equity investing and hedge fund management. For instance, in a private equity investment fund, the general partner (GP) can charge performance fees (known as carried interest) if the limited partner’s rate of return crosses the prearranged hurdle rate.
Hurdle Rate Factors
The hurdle rate balances the need for profit with the risks and costs involved, guiding investment strategy decisions for both individuals and corporations. Key factors in determining the hurdle rate include:
- Risk premium: Reflects the extra returns required for higher-risk projects to compensate for increased risk.
- Inflation rate: Ensures the return on investment exceeds the rising cost of goods and services.
- Interest rate: Represents the cost of borrowing money, forming a baseline for the hurdle rate.
- Cost of capital: Encompasses equity and debt financing costs, reflecting the return expectations of equity owners and lenders.
- Expected rate of return: Must be above the overall return expected from the investment to justify the risk.
What Does the Hurdle Rate Tell You?
Hurdle rates help to calculate the potential success of future endeavors and projects. Companies use them to decide if they will take on a capital project based on its risk level.
If an expected rate of return exceeds the hurdle rate, the investment is deemed sound. Conversely, if the rate of return is below the hurdle rate, management may opt not to proceed.
How to Use Hurdle Rate
Investing
Investors consider the risk premium for potential investments as it captures the anticipated level of risk involved. Higher risks demand higher risk premiums. This premium is typically added to the WACC for a realistic hurdle rate.
Business Projects
Businesses often start with the WACC to evaluate future projects. WACC represents the minimum return needed to satisfy shareholders and debt holders. Calculating the net present value (NPV) helps in evaluating project profitability, with NPV being the sum of discounted cash flows minus initial investment costs.
The internal rate of return (IRR) method compares the profitability of different investment opportunities, providing a complementary perspective to NPV.
Formula and Calculating Hurdle Rates
Example: Assessing a Potential Capital Project
Using WACC and risk premium:
Hurdle rate = WACC + risk premium
Suppose your firm has the following data:
- Common stock: $11,500,000 (60% of total capital), expected return 11%
- Preferred stock: $1,500,000 (8% of total capital), costing 7%
- Debt: $6,250,000 (32% of total capital), interest rate 5%
- Total capital: $19,250,000
WACC calculation:
- WACC = (0.60 X 11%) + (0.08 X 7%) + (0.32 X 5%) = 8.76%
Adding the 10-year U.S. Treasury yield of 4.5% as the risk premium:
- Hurdle rate = 8.76% + 4.5% = 13.26%
Since an ROI of 20% exceeds the hurdle rate of 13.26%, investing in the new equipment would be prudent.
Example from Private Equity
In private equity, the hurdle rate ensures that LPs get a return before GPs start receiving profits. Suppose:
- Fund size: $100 million
- Hurdle rate: 8% annually
- Carried interest: 20% for GPs
Returns above 8% are shared between GPs and LPs, aligning the fund managers’ interests with those of the investors.
Limitations of the Hurdle Rate
Hurdle rates may favor high-percentage return projects even if their dollar value is small. Moreover, choosing a risk premium is challenging, and incorrect rates can lead to flawed decisions.
Hurdle Rate vs. Internal Rate of Return (IRR)
| Factor | Hurdle Rate | Internal Rate of Return (IRR) |
|---|---|---|
| Definition | Minimum return from an investment | Rate at which NPV of cash flows is zero |
| Purpose | Benchmark for investment decisions | Estimates investment profitability |
| Calculation | Predetermined (WACC + risk premium) | Based on project cash flows |
| Decision Criterion | Supports ROI > hurdle rate | Favors IRR > hurdle rate |
| Risk Adjustment | Adjusts for specific risks | Doesn’t directly adjust for risk |
| Capital Budget Use | Fundamental for decision making | Comparisons of project profitability |
How Is the Hurdle Rate Used in Mergers and Acquisitions?
In mergers and acquisitions, the hurdle rate assesses potential value, ensuring expected returns justify the investment.
Can the Hurdle Rate Vary Within a Company?
Yes, varying based on risk profiles of different departments or projects, ensuring higher returns for higher-risk initiatives.
Do Macroeconomic Factors Influence the Hurdle Rate?
Yes, external factors like interest rates, inflation, and market volatility affect hurdle rates, requiring regular reassessment.
The Bottom Line
A hurdle rate is the minimum return required to proceed with a project, guiding companies in risk assessment and investment decisions. Including a risk premium appropriately reflects the risks involved, ensuring sound financial strategies.
Related Terms: Internal Rate of Return (IRR), Net Present Value (NPV), Discounted Cash Flow (DCF), Weighted Average Cost of Capital (WACC).
References
- John D. Finnerty. Project Financing: Asset-Based Financial Engineering. John Wiley & Sons, 2013. Pages 176-181.
- Pierre Vernimmen, et al. Corporate Finance: Theory and Practice. John Wiley & Sons, 2019. Pages 285-94.
