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Explaining Hurdle Rates: Calculations, Considerations and Pitfalls

written by: •edited by: Marjory Pilley•updated: 6/2/2011

When calculating the hurdle rate for a project, the cost of capital of the enterprise is used as a starting point. But, don't stop there! Make sure to adjust it for risky parameters before you give the project a green light.

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    What is a Hurdle Rate?

    The hurdle rate is the minimum rate of return on an investment that will cover all the costs associated with the investment and allow the enterprise to break even on the project. When a project is proposed, the enterprise will examine the expected rate of return and compare this to the hurdle rate. When the rate of return is below the hurdle rate, the project proposal will be rejected by management or sent back for reconsideration and modification to achieve a higher rate of return. Knowing what the hurdle rate is for a project is a critical aspect of the investment decision.

    Capital Project Depending on the enterprise’s procedure for accepting or rejecting projects, management may accept all proposed projects that are expected to achieve a rate of return above the hurdle rate. The enterprise may not, however, have the resources to undertake all proposed projects above the hurdle rate. Therefore, it may make a decision to proceed on the proposed projects with a higher rate than competing proposals.

    The company’s cost of capital is usually used to calculate the hurdle rate. But a risk premium may be added to this to reflect the amount of risk involved in a particular project. Management may proceed by computing the internal rate of return of the project and comparing this to the hurdle rate and to the rate of return on competing project proposals. Another method of analysis would be to find the net present value of the proposed project, using the hurdle rate as the discount rate. If the net present value is negative, the project will be rejected. Any project with a positive net present value may be accepted unless resources are limited and other competing project proposals are preferred.

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    How to Calculate a Hurdle Rate

    Hurdle Rate In order to determine the hurdle rate, first compute the cost of capital. This is the rate of return required by the providers of the company's own capital. Because the return required by the equity shareholders and the loan creditors is likely to differ, the company will normally take the return required by both of these capital providers and compute the weighted average cost of capital. For example, if the company has $1 million of equity capital whose providers expect a 12% return and $2 million of debt whose providers require a 6% return, then the weighted average cost of capital would be computed as one-third of 12% plus two-thirds of 6%, resulting in a weighted average cost of capital of 8%. This result would normally also be adjusted for corporate tax because interest paid to loan creditors is deductible for tax purposes.

    This weighted average cost of capital will be used as a basis for computing the hurdle rate. In some cases, the company could decide that this rate will be used as the hurdle rate for all projects. This provides a rough indication of which projects will break even by covering their costs. An alternative strategy is for the company to set a hurdle rate for each proposed project by taking the weighted average cost of capital as a basis rate and adding a further element for the level of risk attached to the particular project. This is rational as a project that involves a high level of risk would need to achieve a potentially higher rate of return to compensate the company for the amount of risk assumed by accepting the project.

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    Adjustments for High Risk Projects

    The enterprise might identify projects as high risk when the initial outlay is fairly high and the estimated income will be received in the distant future. Although the net present value of the project may be positive, there may be too many unknowns and uncertainties to arrive at a reliable estimate of future income. When determining the hurdle rate for this type of project, it would be reasonable to add a further risk premium to the hurdle rate and require a higher estimated return on the project before making the decision to move forward. An example of a project that might be considered higher risk would be a proposed project by a pharmaceutical company to develop a particular new drug, where the outcome is uncertain and earnings from the developed drug would arise some years in the future. The same would apply to any project to develop new technology which only exists in prototype and where the commercial success of the technology has not yet been proven.

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    Potential Problems

    Proposed Project When evaluating projects an enterprise must attempt to estimate future cash flows as accurately as possible. Careful consideration of the correct hurdle rate is of no help if the cash flow forecasts for proposed projects are not prepared with sufficient accuracy. The analysis of the cash flow must be accurate with regard to both the amounts of the cash flows and to their timing. If it is impossible to estimate future cash flows with sufficient accuracy, then this problem must be taken into account when considering the hurdle rate for that particular project. When a project is long term and the earnings are not anticipated in the near future, the enterprise must take into account the likely changes in market conditions, currency inflation and the competition in their industry. The use of the hurdle rate is only a tool in assisting management decisions and should not exclude the consideration of wider information that can assist management decisions.

    The factors used to calculate the hurdle rate of potential projects must be constantly reviewed. The company's cost of capital does not stay the same and requires frequent revision. As a result, the hurdle rate will require frequent review and adjustment when based upon the cost of capital. Additional premiums that take into account the level of risk for a project must also be reviewed and adjusted in accordance with the changes to the cost of capital. If the hurdle rate is based on outdated calculations it becomes useless for assessing the viability of projects and this will lead to incorrect management decisions.

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    References

    Accounting Tools at http://www.accountingtools.com/hurdle-rate

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