Hurdle rate is the minimum return from an investment project which requires by the shareholder or top management. It is the benchmark that the management used to evaluate any project before investing. This rate will vary from one company to another, as it gets an impact from many other factors such as risk, cost of capital, and return of similar investment.
The hurdle rate allows the company to decide whether to make an investment or not. It is the appropriate compensation which company require in exchange for a certain risk. The company expects to generate a high return from a higher risk project while the lower risk could have a lower return. The investor use a hurdle rate to discount the future cash flow from projects and make a comparison to select the best one.
Factors to consider when setting up Hurdle Rate.
|Factors impact Hurdle Rate|
|Risk premium||The return of investment is closely related to the risk. The higher the risk, the higher the return it should be.|
|Inflation||If the economy is suffering from inflation, we must include it in our rate of return. Otherwise, we will receive less than what we expected.|
|Interest rate||We can simply earn interest by deposit money in the bank and do nothing. So whatever reason, the return on investment must be higher than interest.|
|Cost of capital||It is the cost which the company spends to receive the capital. The company will wish to use this capital to invest and make more than it spends. So the higher the cost of capital, it will lead to a higher hurdle rate too.|
|Risk of investment||Before accepting any new investment, we check both risk and reward. The higher the risk, the higher reward we expect from investment as well.|
How to Use Hurdle Rate?
Hurdle rate is used as the discounted factor for the future cash flow analysis which is the reflection of the time value of money. The company wan to make sure that all the return is converted to present value.
It is also basic for the management to access the risk of new projects before making any investment. It can eliminate investments that have low returns and higher risks.
For example, the board of director has decided to set the hurdle rate of 13%, so the management will only consider any project with a return higher than 13%. They will group all projects and analyze their risk and return.
What are the limitations of Hurdle Rate?
The hurdle is always favor with the high rate project even it generates a lower amount of return. On the other hand, a higher profit project is abandon due to lower returns compared to its initial investment.
Moreover, the hurdle rate mostly relies on the cost of capital which is not fixed. It changes from time to time, so it will lead to the fluctuating of hurdle rate too.
Hurdle Rate vs. WACC
Hurdle rate is the minimum required return on investment while WACC is the average cost of capital. WACC rises from the average of all cost of capital, which includes stock, bond, and other long term debt. Each company has different WACC due to the proportion of capital and the cost to acquire them.
Hurdle rate will be higher than WACC as the company will require a return, which higher than the cost spend. The management or shareholders may require to hurdle rate equal to WACC + X% to cover the cost of operation. However, the company may end up accepting a low hurdle rate when there is excess capital.
Hurdle Rate and High Water Mark
High water mark is the highest point which the investment fund or account has reached since the first establishment. It helps to measure the manager’s incentive and protect the investor. The fund manager usually receives the performance fee which base on the profit generates by the fund. But only if the profit has across the high water mark.
If the high water mark is too high, it will discourage the fund manager to achieve a higher level.