What it means
Every business has more ideas than cash, so it needs a consistent test for deciding which ideas get funded. The hurdle rate sets that test as a percentage return, and it is usually built from the company's cost of capital plus an allowance for the specific risk of the project.
Anything expected to earn less than the hurdle is, in effect, expected to make shareholders worse off. The starting point is normally the weighted average cost of capital, the blended cost of the company's debt and equity funding.
On top of that, finance teams add a risk premium that reflects how uncertain the project is. A familiar equipment replacement might carry a small premium, while entering a new country carries a large one.
Hurdle rates are applied in two main ways. They can be used as the discount rate in a net present value calculation, so a positive net present value means the project cleared the hurdle.
Alternatively, the project's internal rate of return is calculated and compared directly against the hurdle percentage. The nuance most people miss is that the hurdle rate is a management choice, not a fact discovered in the market.
Set it too high and the business rejects sound projects and slowly starves itself of growth; set it too low and it funds marginal work that never repays the capital tied up. Boards therefore review hurdle rates periodically as interest rates and business risk change.
There is also a second, quite different use of the term in fund management. In private equity and hedge funds, the hurdle rate is the minimum return investors must receive before the manager is entitled to a share of the profits, often called the preferred return.
The word is the same, but the mechanism is a fee gate rather than an investment screen.
In practice
Real-world examples.
Example
A hotel group sets a 14% hurdle rate for refurbishment projects. A proposed spa extension is forecast to return 11%, so the capital is redirected to a room upgrade programme expected to return 18%.
Example
A logistics firm uses its hurdle rate as the discount rate in every net present value model. A new depot shows a positive net present value at 13%, which tells the finance director it clears the hurdle without a separate calculation.
Example
A private equity fund agrees an 8% hurdle rate with its investors. The manager receives no performance fee in a year when the portfolio returns 6%, because investors have not yet received their preferred return.
Think of it
“Hurdle rate is the minimum performance bar-what you must beat before sharing profits.
Formula
Calculation
A common formula is: Hurdle rate = Weighted average cost of capital + Risk premium.
Take a manufacturer whose weighted average cost of capital is 9%. The board decides that a proposed automated packing line, which uses proven technology in an existing plant, warrants a risk premium of 3%. The hurdle rate is therefore 9% + 3% = 12%.
The packing line costs $2,000,000 and is forecast to generate $460,000 of net cash inflow each year for eight years, a total of $3,680,000. Its internal rate of return works out at roughly 15%, which is 3 percentage points above the 12% hurdle, so the project is approved. A competing proposal to enter an unfamiliar export market is given a 7% premium, lifting its hurdle to 16%, and its expected 13% return means it is rejected.Case study
Seen in the real world.
Kestrel Fabrication is an invented company used here as an illustrative example of hurdle rate discipline. For years it approved any capital request that promised to pay back within four years, which meant projects of wildly different risk were judged by the same crude test.
A new finance director introduced a tiered hurdle rate. Maintenance and replacement projects had to clear 10%, expansion within existing product lines had to clear 14%, and anything involving a new market or a new technology had to clear 19%. Each proposal now arrived with an expected return calculated the same way.
The immediate effect was uncomfortable, because two pet projects from long-serving managers failed the test and were dropped. Over the next three years, however, the fictional business put its capital into fewer, better projects, and return on capital employed rose from 8% to 13% without any increase in total spending.
Watch out
Common mistakes.
- Using one hurdle rate for every project regardless of risk, which quietly favours risky proposals and penalises safe ones.
- Setting the hurdle rate below the cost of capital, which means approved projects can be expected to reduce the value of the business.
- Treating the hurdle rate as permanent and leaving it unchanged for a decade while interest rates and the company's risk profile move substantially.
Questions
People also ask.
Is the hurdle rate the same as the cost of capital?
Not quite; the cost of capital is the floor, and the hurdle rate is usually that floor plus a premium for project-specific risk.
What happens if a project only just clears the hurdle?
Most boards look for a margin of safety, because forecasts tend to be optimistic and a project at exactly the hurdle has no room for error.
Can a project below the hurdle rate ever be approved?
Yes, when it is compulsory or strategic, such as a safety upgrade or a regulatory requirement, but it should be labelled as such rather than dressed up with flattering numbers.
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