Companies are all aiming towards business growth. Hence, they need to think of ways how to do that. For instance, a manager or an investor may propose an investment or project that will require a hurdle rate or the lowest possible rate of return that they can get out of that. The hurdle rate will describe what can be the compensation for the risk that the company for that specific project. So, the more the risk, the higher the hurdle rate. Many factors affect this rate, including the capital, risks, and gains from other potential projects.
Tell me more about hurdle rates.
So, companies need to calculate the hurdle rate to know whether a new endeavor or project is worth it for them to continue. Of course, all projects come with risks. However, the rate of return should be more than the hurdle rate for the company to give it a shot. It is the break-even yield.
Companies look at two things before going through with projects:
- Discounted cash flow analysis (DCF). There are cash flow discounts because of set rates which the company chooses (hurdle rate). The DCF value depends on the used rate during the discount. To get the net present value (NPV) of the project, we subtract the overall project cost from the total DCFs we got from using the hurdle rate. The NPV approach is made using the DCF analysis. The project is viable if the NPV is positive. The usual hurdle rate that companies use is the WACC or the weighted average cost of capital.
- Internal rate of return (IRR). The project is viable if the IRR is more than the hurdle rate.
How can we use hurdle rates?
When there is a potential project, companies want to know how much risk they will be putting themselves into. Usually, they assign risk premiums. Higher risks mean higher risks premium. In a way, it makes sense that if the risks of losing money from a single project are high, the possible returns should also be higher. For accurate hurdle rates, these risk premiums are added to the WACC.
Sometimes, a company will look at several project proposals simultaneously. And sometimes, they can only accept one or a few of them. And because people have different preferences, the company decides better when there is a hurdle rate. The ones that will be named viable are the ones that have better odds to help them become more profitable. We can use the hurdle rate to show that a project has financial merits without thinking about the assigned intrinsic value. Again, this is possible by risk factor assignment.
Should companies use hurdle rates?
Using hurdle rates is effective when it is used correctly. However, it can also cause missed opportunities. How? These rates will always prefer projects with higher rates of return even when the dollar value is by far lesser. For instance, Project X has a 15% return rate with a $10 profit value.
On the other hand, Project Y has a 12% return rate with an $18 profit value. And since we mentioned that favors are always given to projects with higher return rates, Project X will more likely be chosen even when Project Y is obviously a better option. In this scenario, the hurdle rate did not help the company become more profitable. Furthermore, risk premiums are not precise numbers. The project’s returns will not come out exactly as expected.
We are not saying that hurdle rates are not effective because they can be. At the end of the day, we see that further research, study, and attention to project details are still crucial above anything else. Some tools and strategies can help, but we should not forget the basics.