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What are hurdle rates when choosing investments?
Imagine a world where you confidently sift through investment opportunities, effortlessly separating the wheat from the chaff using a new tool - hurdle rates.
This article promises to guide you through understanding hurdle rates—proving with examples and formulas how they work—and pushes you towards becoming a savvy investor by reading further.
This article promises to guide you through understanding hurdle rates—proving with examples and formulas how they work—and pushes you towards becoming a savvy investor by reading further.
Quote
"Understanding the 'price of risk' is essential in investing. Hurdle rates serve as a fundamental benchmark, distinguishing between what is merely good and what is truly great. It's not just about the returns, but the returns relative to the risks taken."
Big ideas
- Hurdle rates are calculated using the weighted average cost of capital (WACC), tailored to the investment's risk, ensuring risk-adjusted compensation for investors.
- Hurdle rates differ across industries, reflecting the unique risks and expected returns, with the stock market, real estate and tech startups often showcasing varying benchmarks.
- The hurdle rate acts as the discount rate in Net Present Value (NPV) calculations, directly linking investment risk to its potential profitability.
Introduction to hurdle rates
When investing in financial markets or in new capital for a business, this metric serves as a benchmark that projects must surpass to be deemed worthwhile.
It's a concept widely used across various sectors, including private equity, hedge funds, and real estate, serving as a guide to evaluate potential projects or investments.
It's a concept widely used across various sectors, including private equity, hedge funds, and real estate, serving as a guide to evaluate potential projects or investments.
What is a hurdle rate?
A hurdle rate is the minimum gain needed from an investment or project to make it worth taking on.
This figure is not plucked from thin air; rather, it is calculated meticulously using the cost of capital and the innate risk factors involved.
This figure is not plucked from thin air; rather, it is calculated meticulously using the cost of capital and the innate risk factors involved.
If you’ve ever watched a hurdle race, you know the athlete must jump the hurdle to win. Likewise, the expected return on investment must rise above the hurdle rate for an investor to decide it could be a ‘winner’.
The essence of a hurdle rate is intricately tied to opportunity cost because money invested in one area denies the chance of returns from another. As such, setting a minimum return on investments helps in assessing different opportunities on an equal footing.
It’s what private equity firms and hedge funds use to decide where to invest, but the same practice is applied by corporate finance managers to manage their resources efficiently.
The essence of a hurdle rate is intricately tied to opportunity cost because money invested in one area denies the chance of returns from another. As such, setting a minimum return on investments helps in assessing different opportunities on an equal footing.
It’s what private equity firms and hedge funds use to decide where to invest, but the same practice is applied by corporate finance managers to manage their resources efficiently.
How to calculate hurdle rates in 3 steps?
Calculating the hurdle rate involves several steps that take into account the cost of capital and the risk associated with the investment.
Here's a simplified guide to understanding how hurdle rates are determined:
Here's a simplified guide to understanding how hurdle rates are determined:
- Identify the Weighted Average Cost of Capital (WACC)
- Assess the Risk Premium
- Add the Risk Premium to the WACC
The greater the uncertainty of success (or risk), the greater the hurdle rate should be.
The WACC represents the company's cost of capital from all sources, including debt and equity. It serves as the baseline rate of return required to cover the cost of financing the project.
Based on the specific risk factors associated with the investment, such as market volatility, sector risks, or operational risks, determine an appropriate risk premium. This is an additional percentage added to the WACC to account for the increased risk.
The sum of the WACC and the risk premium gives you the hurdle rate. This rate represents the minimum return that an investment must generate to be considered viable.
Based on the specific risk factors associated with the investment, such as market volatility, sector risks, or operational risks, determine an appropriate risk premium. This is an additional percentage added to the WACC to account for the increased risk.
The sum of the WACC and the risk premium gives you the hurdle rate. This rate represents the minimum return that an investment must generate to be considered viable.
The formula behind hurdle rates
FORMULA & EXAMPLE
Hurdle rates are determined by adding a risk premium to the weighted average cost of capital (WACC).
If a company's WACC is 6% and the risk premium for a particular project is estimated at 2%, the hurdle rate for that project would be 8%.
This calculation ensures that the hurdle rate not only covers the cost of capital but also compensates for the additional risk associated with the investment.
If a company's WACC is 6% and the risk premium for a particular project is estimated at 2%, the hurdle rate for that project would be 8%.
This calculation ensures that the hurdle rate not only covers the cost of capital but also compensates for the additional risk associated with the investment.
Fortunately, you don’t need to brush up on your mental maths to calculate a hurdle rate; tools like hurdle rate calculators can simplify this process, allowing you to input specific variables and obtain a benchmark rate.
How to use hurdle rates in different scenarios?
Although the specifics may vary depending on the kind of investment—like in private equities, hedge funds or individual investments—the basic fact remains: there should be some fixed standard for determining the lowest level of acceptable return from any particular venture.
What matters is whether each project's expected ROI exceeds its respective hurdle rate. The amount which would make an investment worth undertaking (the hurdle rate) relates closely with its riskiness i.e. a riskier project with a higher potential return tends to need a higher hurdle rate.
What matters is whether each project's expected ROI exceeds its respective hurdle rate. The amount which would make an investment worth undertaking (the hurdle rate) relates closely with its riskiness i.e. a riskier project with a higher potential return tends to need a higher hurdle rate.
EXAMPLE
If Project A’s anticipated ROI falls below its hurdle rate, then it does not meet whatever minimal amount it requires, considering both costs of capital and inherent risks. Thus, Project A probably shouldn’t proceed because it will not compensate investors fairly well, given that they have taken risks.
On the other hand, Investment B looks attractive if its projected return exceeds its required return since it indicates that there are decent potential profits likely to accrue from getting involved with them. Regarding these formulations, therefore, one can say that since Investment B has gone beyond the “base case” level for returns considered adequate enough besides having remunerated risks.
On the other hand, Investment B looks attractive if its projected return exceeds its required return since it indicates that there are decent potential profits likely to accrue from getting involved with them. Regarding these formulations, therefore, one can say that since Investment B has gone beyond the “base case” level for returns considered adequate enough besides having remunerated risks.
Individual investor scenario
An individual investor employs a hurdle rate of 10% and considers investing in Tesla (TSLA) shares. This rate reflects the minimum acceptable return to compensate for the risks involved, considering both personal financial goals and current market conditions.
If the investor decides the growth potential for Tesla stock is greater than 10%, then it means that this stock satisfies the requirements and becomes a consideration to invest in. Tesla may be too risky for the investor if the expected return is less than 10%, whereby they would look for investment alternatives with a better risk-return trade-off.
If the investor decides the growth potential for Tesla stock is greater than 10%, then it means that this stock satisfies the requirements and becomes a consideration to invest in. Tesla may be too risky for the investor if the expected return is less than 10%, whereby they would look for investment alternatives with a better risk-return trade-off.
Private equity scenario
A private equity fund may set a minimum required annual return of 12%. Thus, if there is any small to medium-sized enterprise (SME) available to acquire, it must be able to demonstrate that the fund can rely on returns above 12%.
Hedge fund scenario
A hedge fund may implement a hurdle rate with a catch-up structure in its performance fee arrangement.
For instance, if the fund sets a hurdle rate of 8%, it only collects performance fees on returns that exceed this benchmark. This motivates the fund to pursue strategies that aim to surpass the hurdle rate, aligning the interests of the fund managers with those of the investors.
For instance, if the fund sets a hurdle rate of 8%, it only collects performance fees on returns that exceed this benchmark. This motivates the fund to pursue strategies that aim to surpass the hurdle rate, aligning the interests of the fund managers with those of the investors.
Advantages and disadvantages of using hurdle rates
While widely used, hurdle rates are shunned by some, who prefer other metrics, discussed shortly.
Advantages | Disadvantage |
Clear benchmark - It provides a clear benchmark for evaluating the viability of an investment and makes sure only good ones are taken. | Difficulty in determination – Determining the right hurdle rate can be difficult as it necessitates a deep understanding of the cost of capital and risk. |
Optimises capital allocation - Hurdle rates simplify capital allocation and resource utilisation by focusing on promising opportunities. | Possibility of missing opportunities - A high hurdle rate could lead to missed profitable investments. |
Protects investor interests – In private equity or hedge funds, it ensures transparency and trust between investors and fund managers. | Needs constant adjustment – Fixed hurdle rates cannot accommodate current economic changes and hence require constant review and revision. |
Comparative analysis: Hurdle rate vs other metrics
Hurdle rates are often compared with different financial metrics in order to get a fuller picture of the situation.
Here’s how they stack up against Internal Rate of Return (IRR), Weighted Average Cost Capital (WACC) and Discount Rate:
Here’s how they stack up against Internal Rate of Return (IRR), Weighted Average Cost Capital (WACC) and Discount Rate:
Hurdle rate vs Internal Rate of Return (IRR)
Although related, the function of hurdle rates differs from IRR. The hurdle rate is a minimum acceptable return on investment, while IRR is the rate at which all the net present value (NPV) of all cash flows from a project will be zero. If any project has an internal rate of return that exceeds its’ calculated required return, then it is accepted.
What really separates them lies in how they are used; the former being a standard for decision-making while the latter is usually used by investors for assessing the profitability on their investments.
What really separates them lies in how they are used; the former being a standard for decision-making while the latter is usually used by investors for assessing the profitability on their investments.
Hurdle rate vs Weighted Average Cost of Capital (WACC)
Usually, WACC forms part of the hurdle rate calculation as it represents a company’s cost of capital from all sources, such as equity and debt. The hurdle rate includes the WACC plus a risk premium that reflects the project’s level of risk. While WACC provides a baseline cost of funding, the hurdle rate includes other considerations to ensure the investment is justified in terms of return.
Hurdle rate vs Discount rate
A discount rate is used for NPV computation. However, unlike hurdle rates that indicate a minimum acceptable return for investment approval, discount rates are designed to determine the present value of future cash flows. Hurdle rate can be seen as one application of discount rates where risk premiums and other factors are tailored to the specific context around any investment.
In essence, these metrics work together with the hurdle rate to provide an overall view of an investment’s potential compared with its risks and costs.
In essence, these metrics work together with the hurdle rate to provide an overall view of an investment’s potential compared with its risks and costs.
Recap
The concept of hurdle rates is widely applied in making decisions on investments as a threshold for what it should yield before becoming worthwhile. These rates are calculated by combining a quite formulaic weighted average cost of capital with a more open concept of a risk premium that is customised per investment.
Hurdle rates find application across various sectors, including private equity and hedge funds, guiding both corporate finance managers and individual investors.
Understanding the distinction between hurdle rates and similar financial metrics such as the internal rate of return, weighted average cost of capital, and discount rate - and knowing how to use them together - will greatly aid your investment decision-making.
Hurdle rates find application across various sectors, including private equity and hedge funds, guiding both corporate finance managers and individual investors.
Understanding the distinction between hurdle rates and similar financial metrics such as the internal rate of return, weighted average cost of capital, and discount rate - and knowing how to use them together - will greatly aid your investment decision-making.
FAQ
Q: Why is hurdle rate important?
As a benchmark for financial performance, it guides capital allocation without suggesting any specific investment choices.
The hurdle rate is essential because it represents the minimum return that an investment must generate in order to be considered viable and helps investors evaluate risk and make informed decisions so as to pursue only those projects expected to exceed this minimum return.
The hurdle rate is essential because it represents the minimum return that an investment must generate in order to be considered viable and helps investors evaluate risk and make informed decisions so as to pursue only those projects expected to exceed this minimum return.
Q: How is a hurdle rate determined?
Various factors, including the cost of capital, risk associated with the investment, and the investment climate, are taken into account when setting a hurdle rate.
Often, these rates represent a minimum acceptable return given a particular level of risk, which ensures that investments should surpass this threshold in order to compensate for this risk. It is determined through strategic financial analysis balancing risks and returns with no specific implementation suggestions given.
Often, these rates represent a minimum acceptable return given a particular level of risk, which ensures that investments should surpass this threshold in order to compensate for this risk. It is determined through strategic financial analysis balancing risks and returns with no specific implementation suggestions given.
Q: Is hurdle rate the same as IRR?
No, the hurdle rate is not the same as the Internal Rate of Return (IRR).
The hurdle rate is a predetermined minimum rate of return on investment, while the IRR is the rate at which the net present value (NPV) of all the cash flows (both positive and negative) from a project or investment equals zero. The IRR can be compared to the hurdle rate to evaluate investment viability.
The hurdle rate is a predetermined minimum rate of return on investment, while the IRR is the rate at which the net present value (NPV) of all the cash flows (both positive and negative) from a project or investment equals zero. The IRR can be compared to the hurdle rate to evaluate investment viability.
Q: What is a hurdle rate example?
An example of a hurdle rate could be a company deciding that all its investments must yield at least an 8% return to cover the cost of capital and associated risks.
If a project is expected to return 10%, it exceeds the hurdle rate and might be considered for investment. This example illustrates the concept without advising on specific investments or strategies.
If a project is expected to return 10%, it exceeds the hurdle rate and might be considered for investment. This example illustrates the concept without advising on specific investments or strategies.
Q: Does NPV use a hurdle rate?
Yes, the Net Present Value (NPV) computation employs the hurdle rate as a discounting factor to determine the present value of future cash flows.
If NPV is positive, then it means that projected earnings exceed the hurdle rate, implying that investment could be worth considering. However, note that this alone does not recommend anything but serves only as information for decision-making.
If NPV is positive, then it means that projected earnings exceed the hurdle rate, implying that investment could be worth considering. However, note that this alone does not recommend anything but serves only as information for decision-making.
Q: Is the hurdle rate the same as ROI?
No, it doesn’t mean the same thing as Return on Investment (ROI).
While the hurdle rate is the minimum return required from an investment, ROI measures the profit/loss generated on an investment relative to the total size of the investment made. The latter calculates in hindsight what has been earned, while the former looks forward to potential returns.
While the hurdle rate is the minimum return required from an investment, ROI measures the profit/loss generated on an investment relative to the total size of the investment made. The latter calculates in hindsight what has been earned, while the former looks forward to potential returns.
Q: What are the advantages of the hurdle rate?
Using a hurdle rate offers several advantages, such as providing a clear benchmark for investment decisions, managing risk by setting minimum return thresholds and aligning projects with the company's strategic objectives.
This helps prioritise investments with a higher likelihood of achieving the desired financial results, though one also needs to weigh up whether using a hurdle rate in any particular investment appraisal constitutes a balanced approach.
This helps prioritise investments with a higher likelihood of achieving the desired financial results, though one also needs to weigh up whether using a hurdle rate in any particular investment appraisal constitutes a balanced approach.
