Hurdle Rate Definition
A hurdle rate is the minimum rate of return that must be achieved
A hurdle rate is the minimum rate of return that must be achieved
A hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors that could directly affect an investment.
Before accepting and implementing a certain investment project, its internal rate of return (IRR) should be equal to or greater than the hurdle rate. However, most importantly, any potential investments must possess a return rate that is higher than the hurdle rate in order for it to be acceptable in the long run.
Most companies use their weighted average cost of capital (WACC) as a hurdle rate for investments. The stems from the fact that companies can buy back their own shares as an alternative to making a new investment, and would presumably earn their WACC as the rate of return. In this way, investing in their own shares (earning their WACC) represents the opportunity cost of any alternative investment.
Another way of looking at WACC is that it’s the required rate of return investors demand from the company. Therefore, any project the company invests in must equal to (or ideally greater than) it’s cost of capital.
A more refined approach is to look at the risk of the individual investments and add or deduct a risk premium based on that. For example, a company has a WACC of 12% and half its assets are in Argentina (high risk), and half its assets are in the United States (low risk). If the company is looking at one new investment in Argentina and one new investment in the United States, it should not use the same hurdle rate to compare them. Instead, it should use a higher rate for the investment in Argentina and a lower one for the investment in the U.S.
In analyzing a potential investment, a company must first hold a preliminary evaluation to test if a project has a positive net present value. Care must be exercised as setting a very high rate could be a hindrance to other profitable projects and could also favor short-term investments over the long-term ones. A low hurdle rate could also result in an unprofitable project.
Key considerations include:
The most common way to use the hurdle rate to evaluate an investment is by performing a discounted cash flow (DCF) analysis. The DCF analysis method uses the concept of the time value of money (opportunity cost) to forecast all future cash flows and then discount them back to today’s value at the hurdle rate to provide the net present value.
In order to do this, the company needs to perform some financial modeling. The first step is to model out all the revenues, expenses, capital costs, etc in an Excel spreadsheet and develop a forecast. The forecast needs to include the free cash flow of the investment over its lifetime. Once all the cash flows are in place, use the XNPV function in Excel to discount the cash flows back to today at the set hurdle rate. If the resulting Net Present Value (NPV) is greater than zero, the project exceeds the hurdle rate, and if the NPV is negative it does not meet it.
As you can see in the example above, if a hurdle rate (discount rate) of 12% is used, the investment opportunity has a net present value of $378,381. It means if the cost of making the investment is less than $378,381 its expected return will exceed the hurdle rate. If the cost is more than $378,381 the expected return will be lower than the hurdle rate.
Learn more about hurdle rates and internal rate of return in CFI’s financial modeling & valuation courses.
The hurdle rate is often set to the weighted average cost of capital (WACC), also known as the benchmark or cut-off rate. Generally, it is utilized to analyze a potential investment, taking the risks involved and the opportunity cost of foregoing other projects into consideration. One of the main advantages of a hurdle rate is its objectivity, which prevents management from accepting a project based on non-financial factors. Some projects get more attention due to popularity, while others involve the use of new and exciting technology.
It’s not always as straightforward as picking the investment with the highest internal rate of return. A few important points to note are:
We hope this has been a helpful guide to hurdle rates. CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification, designed to transform anyone into a world-class financial analyst.
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