The hurdle rate is the rate of return required by investors on some particular project under consideration. It’s an excellent tool to measure the potential of the investment project and helps in deciding if the project should be accepted considering expected returns to be generated from the investment proposal.
Generally, the investment projects with higher risk generate a higher return and the projects with lower risk generate a lower return. Hence, it helps to choose the project in line with the risk appetite of the investors. If an investor is aiming to generate a greater return he/she is assumed to have a higher risk appetite and vice versa.
The hurdle rate is used by accountants and analysts in discounting future cash flow to bring the figures in year zero. The logic behind the idea is to assess if the project is capable to produce returns equal to or in access to the required rate of the investor. If the calculated NPV is greater than zero, it means an expected return is higher than the hurdle rate and the project can be accepted. On the contrary, if NPV is negative it indicates that expected cash inflows are not sufficient to generate the return required by investors.
Further, companies also use a weighted average cost of capital as a hurdle rate to assess if the project is capable to produce a return in excess of the cost incurred by a business. The usage of hurdle rate in the calculation of NPV helps to eliminate personal bias in the selection of the investment opportunity and directs the process of decision-making towards monetary legitimacy.
Another method to assess the potential of an investment opportunity is to compare the hurdle rate with the IRR of the project. If the IRR of the project is higher than the hurdle rate the project seems to be attractive. On the contrary, if the hurdle rate is higher than IRR, the project does not seem to be attractive.
How to calculate the hurdle rate?
The easiest way to calculate the hurdle rate is by calculating the cost of raising finance called weighted average cost of capital and adding required return against risk premium presumed in the form of accepting for the project. The impact of inflation can also be added to the hurdle rate as the value of money might not remain in same in the coming period. Especially, in the case of long-term investments that take years to be completed.
So, there are two components of calculating the hurdle rate. One is to calculate WACC – Weighted Average cost of capital and the other is to calculate risk premium. The WACC can be calculated by values for the equity and debt obtained from the financial statement along with rates of financing for these facilities. The rate of debt can be obtained by documents of obtaining finance and the cost of equity can be calculated by using a calculation model like Capital Assets Pricing Model – (CAPM).
The other component of the calculation is risk premium. It can be calculated by deducting risk free rate from the expected rate of return. Once, these calculations are finalized the WACC and risk premium is combined and you get a hurdle rate that can be used to evaluate investment opportunities.
Example for calculation of hurdle rate
Consider the business has debt amounting to USD 120,000 obtained at the rate of 10% per annum and equity USD 100,000. The cost of equity calculated by the CAPM model is 12%. The investors of the company required a risk premium of 3%.
First, we need to calculate the WACC which can be calculated by calculating financing. The total financing in the company is USD 220,000 (USD 120,000+ USD 100,000). The proportion can be calculated as a proportion of the debt is USD 54.45% (120,000/220,000) and the proportion of equity is 45.45% (100,000/220,000). Hence, we can say the overall proportion is debt 5.45% (10%*54.54%) and the equity proportion multiplied with the cost of equity is 5.46% (45.5%*12%). So, if we combine 5.45% and 5.46% we get 10.91% as the average cost of capital. Since it’s a rate of the cost and we shall add a risk premium in the cost of capital to get the hurdle rate. Hence, the hurdle rate of the company is 13.9% (10.91%+3%).
Limitations of the hurdle rate
The mechanism of hurdle rate favors the investment with higher rates of return. It ignores the absolute figures of the investment opportunities. This mechanism of evaluating investment might select the investment-A with a return of USD 10,000 instead of selecting investment-B with a return of USD 35,000 as investment-A had a higher IRR. Hence, to make a sound investment appraisal the use of hurdle rate in comparison with the IRR is not sufficient.
Importance of hurdle rate
The hurdle rate plays an important role in deciding between the different investment opportunities. It gives a sound mechanism to opt for investment if IRR is greater than the hurdle rate and leave the investment if the hurdle rate is lower than IRR.
Connection between hurdle rate and NPV
The hurdle rate can be used in discounting the cash flows. If the net impact of cash in and out is in the form of a positive cash flow, it suggests that the expected return of the investment is above the required rate of return for the company.
Connection between hurdle rate and IRR
The hurdle rate and IRR are the rates that are compared to assess the financial viability of the project. If IRR is more than the hurdle rate of return the investment seems to be financially viable. On the contrary, if IRR is lower than the hurdle rate the project does not seem to be attractive for the investors.
Rate for NPV calculation
If hurdle rate is used in NPV calculation, the discounting covers the cost of capital and risk premium. So, if calculated NPV is zero it’s acceptable because it has covered both the cost of capital and risk premium. However, if calculated NPV is negative it may be not be covering risk premium and/or cost of capital. However, it NPV is positive even after using the hurdle rate it reflects that project is expected to generate a return even more than the desired rate of return. So, it’s desirable.
On the contrary, if IRR is used in the discounting of cash flow it will produce zero NPV. So, an accountant needs to compare IRR and hurdle rate. If IRR is greater than the hurdle rate the project seems to be attractive and vice versa.