A hurdle rate is the minimum rate of return that should be required on an investment, based on the risk of that investment.
What Is a Hurdle Rate?
A hurdle rate is the rate of return on a project that must be expected to be able to be achieved before management will undertake the project. The hurdle rate is set by management. Bad managers sometimes set arbitrary hurdle rates, which can lead to accepting projects that result in losses for the firm. Good managers calculate a project’s cost of capital and establish it as the project’s hurdle rate. If, after projecting the project’s cash flows and determining the project’s expected rate of return, the expected return is equal to or exceeds the hurdle rate, the project should be undertaken. If, instead, the expected return on the project is less than the hurdle rate, the project should be rejected.
The weighted average cost of capital (WACC) of a firm is generally used as the hurdle rate for a project that is of average risk for the firm. The WACC is the average cost of the securities that a firm uses to finance its operations, which is determined by the rates of return that the firm’s investors (bondholders and stockholders) require on their investments in the firm. If a project is less risky than the average risk project of a firm, its required rate of return (i.e., hurdle rate) should be less than the firm’s cost of capital. Likewise, if a project is more risky than the average risk project that a firm undertakes, it should be required to return more than the cost of capital of the firm.
As an example, assume a firm is in the retail grocery business and has several stores throughout the United States. It is considering opening a new grocery store within the United States and will be financing that new store in the same manner as the firm’s other operations. In this case, it is reasonable to assume the new store will be of average risk for the firm, and, thus, the firm’s cost of capital is the appropriate hurdle rate to use.
Now assume that management has decided to open a pet funeral parlor instead of a new grocery store. A pet funeral parlor is probably a lot more risky that a retail grocery store. Thus, the weighted average cost of capital of the firm would not be an appropriate hurdle rate to use. The hurdle rate should be higher, reflecting the greater risk of the project.
Adopting a higher hurdle rate for a riskier project is somewhat intuitive. Adjusting the hurdle rate downward when a project has less than average risk is less intuitive. Assume that the weighted average cost of capital of the retail grocery store company has been determined to be 10%. The company has some excess funds that it would like to invest for a short period of time. It is considering investing in some U.S. Treasury bills that are currently offering a return of 1.5%. Note that if the firm uses its weighted average cost of capital as a hurdle rate for this investment, it would choose not to invest in the Treasury bills. But Treasury bills are risk-free investments and should not be required to return the firm’s cost of capital. If a firm requires all of its investments to return at least its cost of capital, the firm will become riskier in the long run since it will always accept only projects that are of the same or greater risk than the projects in which it currently invests.
Hurdle Rate Formula
The formula for the hurdle rate of an average risk project of the firm is the formula used to calculate the firm’s weighted average cost of capital:
WACC = pdkd + ppkp +pckc
where pd, pp, and pc are the proportions of debt, preferred stock, and common stock financing that the firm uses, and kd, kp, and kc are the costs of each of these sources of financing.
There are three very important rules to keep in mind when applying this formula:
- Use the market values, not the book values, of the firm’s debt, preferred stock, and common stock when calculating the proportions of financing used. Book values are historical numbers. Market values are the current values, and since we are using the WACC to judge the acceptability of future projects that the firm is considering undertaking, the current values are more appropriate. For this same reason, if management is contemplating changing the proportions of the various types of financing it uses, the expected new proportions should be used in the calculation.
- Use the yield-to-maturity to determine the cost of debt, not the coupon rates on the debt. The yield-to-maturity is what the firm would have to offer as the coupon rate on a bond it issued today since it is what investors are currently requiring as a return on the firm’s debt.
- If the firm is able to deduct the interest it pays on its debt (as it currently can under U.S. tax laws), the after-tax cost of the debt should be used:
kd = yield-to-maturity(1 – firm’s marginal tax rate)
As an example, assume you have gathered the following information for your firm:
|Company’s Capital Structure|
|Book Value||Market Value|
|Bonds (7% coupon, $1,000 face value, 10 years to maturity)||$5,000,000||$4,358,250|
|Preferred stock (100,000 shares outstanding)||$2,500,000||$2,500,000|
|Common stock (1 million shares outstanding)||$12,000,000||$22,000,000|
In addition, you have determined the yield-to-maturity on your firm’s bonds is 9%, and the return required by your preferred stockholders is 10.4% while the common shareholders require an 11.4% return. Your firm’s marginal tax rate is 45%. The hurdle rate for the average risk project of your firm is its WACC, as calculated below:
|Market Values||Proportions||After-Tax Financing Costs|
*Assumption is that dividends are not tax deductible, so the before-tax and after-tax returns on these two financing categories are the same.
Thus, you should reject any project that does not return at least 10.3% if the project is of average risk for your firm.
How the Hurdle Rate Relates to the Internal Rate of Return (IRR)
The internal rate of return (IRR) of a project is the discount rate that makes the net present value of the project’s cash flows equal to zero. It is the yield on the investment. For the majority of projects, if the internal rate of a project is greater than or equal to the hurdle rate for the project, the project should be undertaken. If the IRR is less than the hurdle rate for the project, the project should be rejected since it is not offering the required rate of return on the project. If the project’s cash flows are discounted at the hurdle rate, the net present value of the project will be negative, which means the firm would lose money on the deal.