What Is Hurdle Rate(Examples And Usage Of Hurdle Rate)

What Is Hurdle Rate(Examples And Usage Of Hurdle Rate). This is defined as a minimum rate of return on a project or investment required by a manager or an investor. It enables companies to make important decisions on whether or not to pursue a specific project. What Is Hurdle Rate(Examples And Usage Of Hurdle Rate), How To Understand Hurdle Rates, Usage Of Hurdle Rate,
Example Of Hurdle Rate, Demerits Of Hurdle Rate,
The Factors To Consider When Setting A Hurdle Rate.

The hurdle rate describes the necessary compensation on the risk level present making riskier projects generally have higher hurdle rates than those with less risk.

The following are some of the areas that must be taken into consideration in determining the rate:

Associated risks

Capital cost

The returns of other possible investments or projects.

How To Understand Hurdle Rates

In the business world, Hurdle rates are very important, especially in terms of future endeavors and projects. Based on the level of risk associated with it, companies determine whether they will take on capital projects. The investment is considered sound, with an expected rate of return is above the hurdle rate. If the rate of return falls below the hurdle rate, the investor may choose not to move forward. A hurdle rate is otherwise referred to as a break-even yield.

The two ways the viability of a project can be evaluated are first, a company decides based on the net present value (NPV) approach by performing a discounted cash flow (DCF) analysis. This Cash flows are discounted by a set rate, which the company chooses as the minimum rate of return needed for an investment or project(the hurdle rate). The value of the discounted cash flows relies on the rate used in discounting them. The total cost of the project is then subtracted from the sum of the discounted cash flows with the aid of the hurdle rate to arrive at the net present value of the project. Secondly, the internal rate of return (IRR) on the project is calculated and compared to the hurdle rate. The project will most likely proceed If the IRR exceeds the hurdle rate, the project.

Usage Of Hurdle Rate

Most times, a risk premium is assigned to a potential investment to enable them to denote the anticipated amount of risk involved. The higher the risk, the higher the risk premium should be, as it takes into consideration the fact that if the risk of losing your money is higher, then the return on your investment should be higher. A risk premium is typically added onto the WACC to arrive at a more appropriate hurdle rate.
The usage of hurdle rate to determine an investment’s potential helps to eliminate any bias created by preference toward a project. By assigning an appropriate risk factor, an investor can use the hurdle rate to demonstrate whether the project has financial merit regardless of any assigned intrinsic value.

Example Of Hurdle Rate

Looking at this 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%. What is the hurdle rate?
WACC (5%) + Risk premium (3%) = 8%
As the hurdle rate is 8% and the expected return on the investment is higher at 11%, then purchasing the new piece of machinery would be a good investment.

Demerits Of Hurdle Rate

Typically Hurdle rates favor projects or investments that have high rates of return based on percentage, even if the dollar value is smaller. For instance, project A has a return of 20% and a dollar profit value of $10. Project B has a return of 10% and a dollar profit value of $20. Project A will be most likely chosen because it has a higher rate of return, even though it returns less in terms of overall dollar value. Also, choosing a risk premium is a difficult task as it is not a guaranteed number. if chosen incorrectly, a project or investment may return more or less than expected and this can result in a decision that is not an efficient use of funds or one that results in missed opportunities.

Significance Of Hurdle Rate

The hurdle rate is very important in the business world, it’s also referred to as a break-even especially when it comes to future endeavors and projects. If an expected rate of return is above the hurdle rate, the investment is considered to be sound, and if the rate of return falls below the hurdle rate, the investor may choose not to move forward.

Determination Of Hurdle Rate

Arbitrary, companies can choose a hurdle rate to discount the cash flows arriving at the net present value (NPV) of the project. The company will approve the project if the NPV is positive. However, most companies add a risk premium to their weighted average cost of capital (WACC), which is the overall required return, and also set that as the hurdle rate. In determining a hurdle rate most companies use their weighted average cost of capital (WACC) as a hurdle rate for investments.

This happens 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, that is earning their WACC represents the opportunity cost of any alternative investment. Another way of determining 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 ideally greater than or equal to its cost of capital.

A more appropriate approach is to look at the risk of individual investments and add or deduct a risk premium based on that. For instance, a company has a WACC of 12% and half its assets are in Argentina (high risk), also 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, then 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.

The Factors To Consider When Setting A Hurdle Rate

In considering a potential investment, a company must first hold a preliminary evaluation to test. If a project has a positive net present value. Adequate care must be taken as setting a very high rate could be a hindrance. To other profitable projects and could also favor short-term investments. Over long-term ones and also a low hurdle rate could result in an unprofitable project. The key consideration is;

Risk premium – For the anticipated risk involve with the project, assign a risk value. Riskier investments generally have greater hurdle rates than less risky ones.

Inflation rate – There are instances when inflation may be the most significant factor to consider. If the economy is experiencing mild inflation, that may influence the final rate by 1%-2%.

Interest rate – This represents an opportunity cost that could be earned on another investment. Therefore any hurdle rate needs to be compared to real interest rates.

How To Evaluate An Investment Using The Hurdle Rate

In evaluating an investment. The most common way to use a hurdle rate is by performing a discounted cash flow (DCF) analysis. This method uses the concept of the time value of money (opportunity cost). To foretell all future cash flows and then discount them back. Today’s value provides the net present value.

To achieve this, the company needs to perform some financial modeling. By first modeling out all the revenues, expenses, capital costs, etc., in an Excel spreadsheet and developing a forecast. This 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. Then the project exceeds the hurdle rate, also if the NPV is negative it would not meet it.

Important Of Hurdle Rate In Capital Investment

This rate is often set to the weighted average cost of capital (WACC). Which is also known as the benchmark or cut-off rate. This is utilized to analyze a potential investment. Generally taking the risks involved and the opportunity cost of foregoing other projects into consideration. Hurdle rate objectivity is one of its main advantages that prevent management from accepting a project based on non-financial factors. Due to popularity, some projects get more attention while others involve the use of new and exciting technology.

Limitations Of Using A Hurdle Rate

This is not always straightforward as picking the investment with the highest internal rate of return. Here are a few important points to note:

Even if the dollar amount (NPV) is very small, Hurdle rates can favor investments with high rates of return.

At a lower rate of return. They may reject huge dollar value projects that may generate more cash for the investors.

The capital cost is usually the basis of a hurdle rate and it may change over time.

Calculating A Hurdle Rate

Hurdle rate usually consists of two elements;1. The company’s cost of funds/cost of capital. This is usually the WACC or weighted average cost of capital
2. A risk premium that depends on the riskiness of a project. Here’s the formula for calculating a hurdle rate:

Hurdle rate = WACC + risk premium (to account for the risk associated with a project’s cash flows)

For example, if the cost of funds for ABC Inc. is 7% p.a. when evaluating projects. Managers at ABC Inc. would add a risk premium, say 4% p.a. for projects with more uncertain cash flows. While only adding 0.5% p.a. for projects that have predictable and less risky cash flows. This would yield a hurdle rate of 7% + 4% = 11% p.a. For risky projects and 7% + 0.5% = 7.5% p.a. For low-risk projects with the addition of a risk premium. To the cost of capital (WACC). In determining the hurdle rate, the managers of ABC Inc. will make a fair comparison between projects. Because a low-risk project does not look as attractive on paper due to its smaller potential cash flows. Which do not make it an unworthy selection. After including risk in the equation. The manager could find out that the low-risk project is actually expected to yield a higher net present value.

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