What is a Hurdle Rate?
A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. It allows companies to make important decisions on whether or not to pursue a specific project. The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk.
In order to determine the rate, the following are some of the areas that must be taken into consideration: associated risks, cost of capital, and the returns of other possible investments or projects.
How a Hurdle Rate Works
We begin building a hurdle rate with a risk-free rate of return. U.S. Treasury notes and bonds typically are used as a risk-free rate of return because there is virtually no chance the investment will fall short of expectations. Investments that have a return greater than the risk-free rate of return offer a “risk premium” to the investor. To calculate the hurdle rate, some investors add the risk premium and risk-free rate of return.
Investors could use the historical risk premium of the S&P 500 rate of return in excess of the U.S. Treasury 10-year bond to calculate the risk premium. The average of the U.S. equity risk premium from 1926 to 2020 was 6.43% above risk-free return rates, based on the S&P 500’s historical risk premium.1
Based on the U.S. Treasury 10-year bond rate, the risk-free rate of return in the summer of 2021 was 1.33%.2 Therefore, the hurdle rate would be 7.56% x (6.43% + 1.33%).
So, if you project that an investment can bring in 11% returns and the hurdle rate is 7.56%, you might consider the investment a good one because you may earn a return of more than 3% above the hurdle rate.
The hurdle rate is often used as the discount rate for a net present value calculation, too. Here’s why that’s important: If you have an opportunity for a franchise, rental property, or your business, the net present value (NPV) is a standard financial measure that can be used to evaluate and compare investments based on their potential for cash flow.
If you were considering buying a rental property here’s how you might look at it:
- Purchase price: $250,000
- Projected 10-year rental income: $18,000 per year
- Discount rate: Hurdle rate of 7.56%
- Present value of $18,000 received for 10 years discounted at 7.56%: $123,216
The present value of the projected rental income at the hurdle rate is less than the initial investment of $250,000. If your goal is to break even after 10 years based on a 7.97% discount rate, this investment won’t do it.
What are the Methods Used to Determine a Hurdle Rate?
Most companies use their weighted average cost of capital (WACC) as a hurdle rate for investments. This 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 the hurdle rate is that it’s the required rate of return investors demand from a company. Therefore, any project the company invests in must be equal to or ideally greater than its cost of capital.
A more refined approach is to look at the risk of 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.
Why Is Hurdle Rate Important?
A hurdle rate, also referred to as a break-even yield, is very important in the business world, especially when it comes to future endeavors and projects. Companies determine whether they will take on capital projects based on the level of risk associated with it.
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, the investor may choose not to move forward.
What are the Limitations of Using a Hurdle Rate?
It’s not always as straightforward as picking the investment with the highest internal rate of return. A few important points to note are:
Hurdle rates can favor investments with high rates of return, even if the dollar amount (NPV) is very small.
They may reject huge dollar value projects that may generate more cash for the investors but at a lower rate of return.
The cost of capital is usually the basis of a hurdle rate and it may change over time.
Hurdle Rate Example
Let’s take a look at a simplified example. Amy’s Hammer Supply is looking to purchase a new piece of machinery. It estimates that with this new piece of machinery, it can increase its sales of hammers, resulting in a return of 11% on its investment. The WACC for the firm is 5% and the risk of not selling additional hammers is low, so a low-risk premium is assigned at 3%. The hurdle rate is then:
WACC (5%) + Risk premium (3%) = 8%
As the hurdle rate is 8% and the expected return on the investment is higher at 11%, purchasing the new piece of machinery would be a good investment.