TheStreet

Believe it or not, you deal with hurdle rates in your day-to-day life.

You probably don't think of it this way. You almost certainly don't use the term (if you do, reconsider your party conversation immediately). But even though hurdle rates are an essential part of business and finance, they'll pretty quickly sound familiar.

Here's why.

What Is A Hurdle Rate?

The hurdle rate is the minimum return that a business needs before it will launch a project or other form of investment. This is otherwise known as the target rate, the required rate of return or the minimum acceptable rate of return.

A company uses the hurdle rate to decide whether to make an investment, such as launching a new project or buying a security. Before a company moves forward with an investment it must expect a rate of return that matches or exceeds the hurdle rate. An investment that returns below the hurdle is typically considered either too risky to justify or, in some cases, unprofitable compared to other alternatives.

A company may set its hurdle rate institutionally, establishing a general rate of return that it requires from viable projects. In the alternative it might also use a project-specific hurdle rate, analyzing each project based on current circumstances.

What Key Factors Determine a Hurdle Rate?

A company sets and evaluates the hurdle rate based on a combination of factors, including but not limited to:

Cost of Capital

This is what it will cost the company to get the money it will use on this investment. Costs of capital include the interest rate on any borrowed money, taxes and shareholder returns.

Alternative Investment Opportunities

Other projects and investments the company is considering. For example, if a company has an opportunity with an anticipated rate of return at 5%, it will likely require that any alternative meet or exceed that return. This is not always part of a formal analysis, but a company may consider it nonetheless.

Risk of the Investment

The risk premium associated with this investment. The higher the chance of loss, the more profitable an investment must be in order to justify it, and the higher the risk premium.

Base Rate of Return 

The rate of return for a zero-risk investment. Typically, this is the rate of a 10-year Treasury bond. Since this is always available, a company will need any project to meet or exceed this return. This is part of the calculation for risk premium.

The Project's Rate of Return

Otherwise known as the Internal Rate of Return (the IRR), this is what the company expects to get back from its investment. It compares the IRR to the hurdle to decide whether an investment is sound.

How Do You Calculate a Hurdle Rate?

The standard formula for calculating a hurdle rate is to calculate the cost of raising money, known as the Weighted Average Cost of Capital (WACC), then adjust this for the project's risk premium. This gives your hurdle rate. You then calculate the anticipated return, the IRR, and compare it to the hurdle. This gives you your cost/benefit analysis.

The WACC

This is how much it costs the company to acquire capital. It is the calculation of how much, on a per-dollar basis, a company needs to return to its investors for every $1 it raises. It is the key component of the hurdle because the WACC is the bottom line. If a company, say, needs to pay its investors 5 cents for every dollar raised, then it cannot accept an investment which returns less than 5%.

While getting into the full calculation of WACC is beyond the scope of this article, the formula proportionally weighs a company's three main forms of financial obligation: Equity (shares), debt and taxes. It is expressed as:

WACC = ((Total Value of Shares/Total Value of the Company) * Rate of Return on Shares) + [((Total Value of Debt/Total Value of the Company) * Interest on Debt) * (1 - Tax Rate on Company)]

The important thing for a hurdle calculation is this: The WACC is ultimately what it costs to raise money after accounting for taxes and debt. No investment is worthwhile unless it returns at least that amount.

Risk Premium

The risk premium is expressed as a percentage, and is how much more you expect an investment to return based on the risk that it will fail. A high-risk venture would have a considerably higher risk premium, for example, indicating that you should demand a larger return in exchange for the risk of losing your money.

Like the WACC, fully discussing risk premium calculation is beyond the scope of this article, however the basic formula is expressed as:

Premium = Return on Investment - Return on Risk Free Investment.

So, for example, let's say you have $10,000 to invest. You could invest it in Treasury Bonds, the typical safe investment option. Let's assume they're paying 3% currently, so you would make $300. You could also invest in Grow Co., a potentially risky stock. The riskier you consider Grow Co., the more you would want to get in return for your investment. Your risk premium would be the amount you'd like Grow Co. to pay you above and beyond a Treasury Bond.

If, for example, you want $1,000 back, your premium would be: $1,000 - $300 = $700. You want a 7% premium for investing in this risky stock.

Calculating the Hurdle

To calculate the hurdle you combine these two factors. A company's hurdle for any given project is its WACC (how much it needs to make off an investment to pay its shareholders) plus the risk premium for the project (how much more it demands from that project based on the likelihood of loss). This represents the bottom line adjusted upward for risk of failure.

Occasionally a firm will also account for inflation, particularly for long-term investments or if high rates of inflation are expected. Finally, depending on the circumstances, a company might adjust its hurdle based on alternative investment opportunities. If it already has an existing investment opportunity, it might require any new project to meet or exceed the previous offer before considering it.

Example

Let's consider an example of the hurdle rate in action.

Widget Co. has the opportunity to invest in a new factory. It expects that with the expanded capacity it can increase sales, leading to an 8% return on its money per year. It has a WACC of 4%, meaning that after accounting for debt and taxes its investors expect profits of 4 cents on the dollar. Widget Co. anticipates a low risk that its additional widgets won't sell, putting that premium at 2%.

Its hurdle, therefore, would be:

• WACC (4%) + Risk Premium (2%) = 6%

Since Widget Co. expects that its new factory will generate a higher rate of return, it can invest confidently.

On the other hand, let's say Widget Co. has a corporate portfolio with a mutual fund that historically returns a steady rate of 9% a year. In this case, the company might adjust its hurdle to 9%, on the theory that no project is worth investing in unless it can beat this alternative.

The new factory, at an 8% rate of return, would fail to meet this standard.

What Are the Limitations of a Hurdle Rate?

There are two significant limits to the hurdle rate.

The first is risk adjustment. Risk premiums, despite their formula, are closer to an art than a science. You can never be certain whether an investment will succeed or fail. Although expressing risk premiums as a number gives the impression of certainty, at the end of the day this is simply someone exercising their best judgment.

The second, and bigger, limit on using the hurdle is that it favors high-percentage returns. This can often mask more net-lucrative investments based on the size of the initial investment. For example, someone who invests $100 and gets back $20 in profit has realized a 20% return. Someone else who invests $500 and gets back $50 in profit has only realized a 10% return.

A hurdle analysis would tell you that the first investment is twice as good as the second, even though the second investment netted substantially more money.

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