Hurdle rate is the minimum return from an investment project which required by the shareholder or top management. It is the benchmark that the management used to evaluate any project before investing.
Capital is a limited resource for most of the company, they need to raise it from the shareholders or borrow from creditors/investors. If they raise cash from debt, they need to spend costs to obtain the loan or bonds. If they raise from issue equity, they need to make a return from the investors’ cash otherwise they will dump the share and invest in other places.
This rate will vary from one company to another, as it gets impacted by many other factors such as risk, cost of capital, and return of similar investment. Different investors may have different levels of expectation, so it will impact to the company’s hurdle rate. They may invest in the company’s future rather than the profitability. In the current situation, it is no surprise to see the investors put millions of dollars into a company that is not making any profit.
The hurdle rate allows the company to decide whether to make an investment or not. It is the appropriate compensation that company requires 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 uses a hurdle rate to discount the future cash flow from projects and make a comparison to select the best one.
In recent situations, there are many projects which claim to be making high returns on investment. Many startup companies are making a great business, so companies will only invest in the highest return. So the board of directors will set a minimum level of return to be considered as a new investment.
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 depositing money in the bank and doing nothing. So whatever reason, the return on investment must be higher than interest.|
|Cost of capital||It is the cost that 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 the higher the 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.|
Hurdle Rate Example
Company ABC has raised $ 10 million for the new investment for next year. Based on the management, the return must be more than 12% over the initial investment.
The CFO has raised three investment projects including:
- Project A: generate 9% per year
- Project B: generate 12% per year
- Project C: generate 15% per year
Please use the hurdle rate to select the best investment opportunity.
Based on the company policy, it only invests in the project which can generate a return of at least 12%. So based on the profit, ABC must select project C which has the highest return amount of the three projects above.
However, it is only one of the factors to consider before making any investment. In real life, we need to check with many other factors to evaluate the project.
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 directors 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 favored by the high-rate project even if it generates a lower amount of return. On the other hand, a higher profit project is abandoned 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 a fluctuating hurdle rate too.
Important of Hurdle Rate
- Easy and simple: It is a very simple rule that top management or board of directors can set for the middle management to evaluate the new investment project.
- Focus on the profit for shareholders: it is the method that maximizes the shareholders’ wealth by investing in the high return project.
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, bonds, and other long-term debt. Each company has a 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 is 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 that the investment fund or account has reached since its first establishment. It helps to measure the manager’s incentive and protect the investor. The fund manager usually receives the performance fee which based 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.