Hurdle Rate: What It Is and How Businesses and Investors Use It

What Is a Hurdle Rate?

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 important when companies or investors make important decisions like pursuing a specific project. Riskier projects generally have higher hurdle rates than those with less risk.

The term is also often used in private equity investing and hedge fund management. For example, in a private equity investment fund, the general partner (GP) can only 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. This concept is crucial in guiding individual and corporate investment strategy decisions.

When determining the hurdle rate, several key factors are taken into account:

• Risk premium: This part of the hurdle rate accounts for the level of risk associated with the investment. Higher-risk projects typically demand higher risk premiums, reflecting the extra returns investors require to compensate for the increased risk. The risk premium is often calculated based on the industry, market volatility, and the specific risks of the project.
• Inflation rate: Inflation can erode the value of returns over time. The expected inflation rate during the investment period should be considered when setting the hurdle rate. Including the inflation rate ensures that the return on the investment exceeds the nominal cost of capital and keeps pace with the rising cost of goods and services.
• Interest rate: Interest rates, often reflected in the cost of debt, are another critical part, representing the cost of borrowing money. For investments funded through debt, the interest rate on the borrowed capital forms a baseline for the hurdle rate since the investment must generate enough return to cover this cost.
• Cost of capital: This is broader, comprising equity and debt financing costs. The cost of capital reflects the return that equity owners and lenders expect on the funds they spend. Calculating the cost of capital often involves weighing the cost of debt (with the interest rate) and the cost of equity, which can be trickier to estimate and usually includes the risk premium.
• Expected rate of return: The hurdle rate must be above the overall return expected from the investment. If the projected return on investment (ROI) is below the hurdle rate, it may be deemed too risky or not profitable enough to pursue.

What Does the Hurdle Rate Tell You?

Hurdle rates are important, especially when calculating the potential success of future endeavors and projects. Companies determine whether they will take on a capital project based on its risk level.

If an expected rate of return is above the hurdle rate, the investment is considered sound. If the rate of return falls below the hurdle rate, management may choose not to move forward. A hurdle rate is also called the break-even yield.

How to Use Hurdle Rate

Investors and businesses use hurdle rates to evaluate an investment or project's potential.

Investing

Investors look at the risk premium for a potential investment since it captures the anticipated amount of risk involved. The higher the risk, the higher the risk premium should be. Risk premiums are typically added to the WACC for a more realistic hurdle rate.

Using a hurdle rate to determine an investment's potential helps to take our feelings or preferences for it out of the equation. By assigning a realistic risk factor, an investor can use the hurdle rate to assess whether the project has financial merit despite its intrinsic value.

Business Projects

When businesses assess future projects, they often begin with the WACC, which conveys the average rate a company is expected to pay to finance its assets, accounting for its equity and debt. The WACC is calculated by weighing the cost of each capital component (equity, preferred stock, and debt) according to its proportion in the overall capital structure. In practical terms, WACC is a benchmark that presents the minimum return a company must generate on its projects to satisfy its shareholders and debt holders. When a company evaluates new projects, using WACC plus the risk premium ensures that these initiatives are expected to yield returns at least equal to the company’s current cost of capital plus the risk premium. This aligns management decisions with the expectations of investors.

Companies can use the net present value (NPV) approach as part of their assessment. NPV involves calculating the difference between the present value of cash inflows and outflows over the project’s life span. Future cash flows are estimated and then discounted to their present value using a discount rate, typically the hurdle rate, which is often the WACC. The NPV is the sum of these discounted cash flows minus the costs for the initial investment cost. If the NPV is positive, the projected earnings (discounted to present value) are higher than the expected costs, suggesting the project is likely profitable.

There is also a method that uses the internal rate of return (IRR), the discount rate that makes the NPV of all cash flows from a project equal to zero. Essentially, it represents the break-even rate of return expected from the project. Thus, a project is generally considered viable if its IRR is greater than the hurdle rate, which is often set as the WACC. The IRR method is handy for comparing the profitability of different investment opportunities, providing a rate of return perspective that complements the absolute value approach of NPV.

Formula and Calculating Hurdle Rates

An Example Assessing a Potential Capital Project

Since the hurdle rate is the lowest return a company expects from an investment to justify the risk, we can use the WACC to help calculate this rate. The WACC reflects the average rate of return a company must earn on its investments to satisfy its shareholders and debt holders. Let's say you manage a company evaluating investing in sophisticated manufacturing equipment. Your engineers estimate the new equipment could result in a 20% increase in production efficiency, that is, an ROI of 20%.

Here is the standard formula for the hurdle rate for companies weighing an investment:

• Hurdle rate = WACC + risk premium

A simplified WACC calculation makes this quicker and easier. You just need the following to calculate it:

• Value of common stock outstanding
• Value of preferred stock outstanding
• Value of total debt
• Interest rates on each
• The current yield on the 10-year U.S. Treasury

Suppose this is the financial data for your firm:

• Common stock: $11,500,000 (60% of total capital), with an expected return of 11%.
• Preferred stock: $1,500,000 (8% of total capital), costing 7%.
• Debt: $6,250,000 (32% of total capital), with an interest rate of 5%.
• Total capital: $19,250,000.

To arrive at the table below, we determine the proportional weight of the firm's capital components (common stock, preferred stock, and debt). First, we calculate the weighted cost of each. Then, we multiply each component's cost or return rate by its proportional weight in the total capital structure. Finally, we total up these weighted percentages:

• WACC = (0.60 X 11%) + (0.08 X 7%) + (0.32 X 5%) = 8.76%

We now need the other element in the equation for the hurdle rate, namely the risk premium.

In finance, a risk premium is the extra return above the risk-free rate that investors demand for taking on extra risk. Virtually all investments carry more risk than U.S. Treasurys. So, we can use the yield on the 10-year U.S. Treasury as the benchmark for the "risk-free rate." Incorporating the 10-year Treasury yield as a risk premium into the hurdle rate helps ensure that it makes up for the market risk (represented by the WACC) and the opportunity cost of investing in the new manufacturing equipment.

In this example, we assume the 10-year Treasury yields 4.5%.

• Hurdle rate = 8.76% + 4.5% = 13.26%.

Since the estimated return on investment of 20% is greater than the hurdle rate of 13.26%, purchasing the new machine would be prudent. The investment is expected to yield returns that exceed the minimum rate required to justify the risk and cost of capital. If, however, it were only expected to yield 10%, it should probably be passed over.

An Example from Private Equity

In private equity, the hurdle rate has a slightly different meaning, referring to the minimum rate of return a fund has to achieve before the general partners (GPs) or managers start receiving a share of the profits, known as carried interest. It acts as a performance threshold that ensures limited partners (LPs) get a certain return on their investment before the general partners receive theirs. Hurdle rates in private equity typically range from 7% to 8% but can vary based on the fund's strategy and the agreement between LPs and GPs. Only after reaching the hurdle rate do GPs start receiving their share of the profits, often about 20% of the fund's returns above the hurdle rate.

Suppose a private equity fund has the following details:

• Fund size: $100 million.
• Hurdle rate: 8% a year.
• Carried interest: 20% for the GPs.

If the fund's return is below 8%, all returns are distributed to the LPs, and the GPs do not receive carried interest. Any returns above the 8% hurdle rate are shared between the LPs and the GPs, who receive about 20% in this example. This arrangement aligns the interests of the fund managers with those of the investors, giving an incentive to the GPs to exceed the hurdle rate to achieve their share of the profits.

There are variations in hurdle rate structures. Some private equity funds employ a fixed hurdle rate, while others might link it to a benchmark, making it variable. There can be tiered hurdle rates in more complex arrangements, with different levels of carried interest rates applying up a ladder of performance thresholds.

Limitations of the Hurdle Rate

Hurdle rates typically favor projects or investments with high rates of return on a percentage basis, even if the dollar value is smaller. Suppose project A has a return of 20% and a dollar profit value of $10, and project B has a return of 10% and a dollar profit value of $20. Project A would be more likely chosen because it has a higher rate of return, even though it returns less in terms of overall dollar value.

In addition, choosing a risk premium is difficult since it's not guaranteed. A project or investment may return more or less than expected. If the rate is chosen incorrectly, it can result in a flawed use of funds or missed opportunities.

Hurdle Rate vs. Internal Rate of Return (IRR)

The hurdle rate and IRR are both key financial metrics used in investment and capital budgeting, but they serve different purposes and are used in different ways.

The hurdle rate is essentially the minimum acceptable return on an investment. It is often set at the company's WACC added to the risk-free rate, although it can be adjusted higher for riskier projects. It is used as a benchmark to determine whether an investment is worth pursuing. If the expected return on a project is higher than the hurdle rate, the project is typically considered viable. The hurdle rate is, therefore, formulated before the assessment of an investment.

The IRR, however, is the rate at which the net present value (NPV) of all the cash flows (both positive and negative) from a project or investment equals zero. It is used to estimate the profitability of potential investments. A higher IRR indicates a more profitable investment. Unlike the hurdle rate, the IRR is calculated based on the expected cash flows from the project.

The Bottom Line

A hurdle rate is the minimum rate of return required for a company or investor to go ahead with a project. Most companies factor in a risk premium when determining their hurdle rate, assigning a higher rate to riskier projects and a lower rate to projects with more moderate risks. Also known as break-even yield, the hurdle rate is very often a key factor in guiding investment decisions.