When companies or businesses make decisions about new projects, they go through complex decision-making processes. One of these processes includes capital budgeting, through which companies can measure the returns they get. Using this process, they can estimate the increase in wealth they can provide shareholders through making investments.
There are several tools that companies can use to estimate the returns they can get on their investments. These may include payback period, net present value, internal rate of return, return on capital employed, etc. Companies usually use a combination of these for decision-making purposes. Among these tools, companies can also use the hurdle rate.
What is the Hurdle Rate?
A hurdle rate refers to the minimum rate of return that companies or investors require on their projects. It is also known as the minimum acceptable rate of return (MARR). It is among the tools that help companies make critical decisions about investing in projects. Companies usually assess several factors when calculating this rate. These include the risks and returns on a possible investment, the cost of capital, etc.
It defines the appropriate compensation for the risk that companies are willing to accept on investments. Before making a decision about an investment, companies calculate the project’s net present value (NPV). Using that information, they calculate its internal rate of return (IRR). For a project to be feasible for a company, its hurdle rate must be equal to or greater than its hurdle rate.
Generally, a project that has a hurdle rate above the IRR will be profitable in the future. Therefore, companies calculate this rate to determine if a project will increase shareholders’ wealth. If a project has a hurdle rate lower than the IRR, the company will decline it. Companies can also compare this rate for various projects to determine the highest returns they can get.
How do Companies Determine the Hurdle Rate?
There is no formula or rule on how to calculate the hurdle rate. This rate will differ according to a company and its requirements. Mostly, companies use the weighted average cost of capital (WACC) as a hurdle rate. It is because WACC considers both the cost of equity and the cost of debt for a company. Therefore, a hurdle rate above rate implies that the company will recover these costs while also making a profit.
Usually, companies assign a risk premium to a project as a measure of the risk it involves. The risk premium will be high for projects that have higher risks associated with them. It is because it considers the possibility of losing money on the investment. Once companies determine the risk premium for a specific project, they add it with WACC to obtain a hurdle rate for investments.
Through this approach, companies can achieve two things. Firstly, by considering WACC in the hurdle rate calculation, companies can assure they will include the cost of equity and debt. On top of that, it helps in ensuring that the company can recover these costs for investors. Secondly, by considering a risk premium, companies can ascertain they will make a profit.
Apart from WACC and risk premium, companies may also include other factors when calculating the hurdle rate. These include inflation and interest rate. The inflation rate helps companies ensure they don’t suffer due to inflation fluctuations in the economy. Similarly, by considering the interest rates, companies also ascertain they account for the opportunity costs of other investments. However, both of these don’t contribute to this rate significantly.
What is the Importance of the Hurdle Rate?
As mentioned, the hurdle rate is crucial for decision-making. Companies using this rate can ensure that they can recover the investments they make. Companies can set this rate at WACC or add factors such as the risk premium, inflation rate, or interest rate. It also allows companies to make objective decisions.
Another reason why companies need it is that it makes the decision-making process straightforward. Setting a percentage for the acceptable rate ensures a company’s management doesn’t include any non-financial aspects of an investment. Similarly, the decision-making rule is straightforward. If an investment’s hurdle rate exceeds its IRR, the investment is considered profitable.
What are the Limitations of the Hurdle Rate?
It does not consider the monetary returns on a project. Instead, it simplifies the process based on using percentages. While the simpler process is faster, it can lead to companies accepting projects that yield higher monetary returns despite a higher IRR. In these circumstances, a project’s NPV can provide better results.
Similarly, establishing a risk premium for projects may not be as straightforward. While it is not a requirement to add the risk premium to the hurdle rate, most companies do so. It can result in varying returns gotten on different projects. On top of that, a company’s cost of capital may change over time, which can result in differing hurdle rates.
The hurdle rate is a metric that companies use to specify the rate of return they require on projects. It depends on a project’s internal rate of return (IRR). If a project’s hurdle rate is higher than its IRR, the project is considered feasible. Using this rate has many advantages, but it may also come with some disadvantages, as mentioned above.