Lisa Borga
Last Updated: May 10, 2022
Date Published: May 10, 2022

## What is a Hurdle Rate?

A hurdle rate is the minimum rate of return that a company or investor is willing to accept in order to make an investment.

What this means is that in order for the individual or company to make an investment of capital, the potential rate of return must meet or exceed the hurdle rate for the investment.

A company’s hurdle rate for an investment, also known as a minimum rate of return or target rate, plays a significant role in making capital budgeting decisions.

When determining a hurdle rate, an investor or company should consider potential risks, the opportunity cost of choosing not to pursue other possible investments, and the cost of capital.

A hurdle rate should always be at a minimum the company or investor’s cost of capital, though in most cases, it will be greater than this.

### Hurdle Rate Explained

Hurdle rates play a significant role in capital budgeting by acting as a benchmark for comparing different possible investments or projects.

The hurdle rate acts as the absolute minimum that a company or investor will accept in order to consider an investment worthwhile.

The hurdle rate accounts for the risk that an investment will not provide the expected returns.

When an investment has a higher risk, an investor will expect to be compensated with higher returns.

An investment that meets or exceeds the hurdle rate is considered to be a suitable investment and should be pursued; however, if an investment falls below the hurdle rate, it is not considered to be worth the investment of capital.

## Setting a Hurdle Rate

There are actually several numbers that a company may use when setting a hurdle rate for an investment or project.

Three of the most common numbers used in calculating a hurdle rate include the weighted average cost of capital, historical equity risk premium, and implied equity risk premium.

### Weighted Average Cost of Capital

The most commonly used hurdle rate uses a company’s weighted average cost of capital as the base with an added premium for risk.

A company’s weighted average cost of capital measures its cost of raising capital from all sources.

This is calculated by weighing the costs of equity and debt financing and balancing them according to the proportion they make to the company’s overall capital structure.

This provides an indication of how much the company can expect to pay in raising the capital to fund a project.

The historical risk premium is the average difference between an equity market’s returns (such as the S&P 500) and the risk-free rate of return.

Generally, an extremely low-risk investment such as a three-month U.S. Treasury Bill is used as the risk-free rate.

This provides an indication of what a company or investor could earn from accepting the higher risk of an equity investment over a risk-free investment based on historical data.

The implied equity risk premium provides a forward-looking estimation of the possible returns a company could earn from investing in the stock market over a risk-free investment.

This provides an indication of the amount that a company could earn from investing in equity over a risk-free investment based on projections of future equity markets.

In setting a hurdle rate for a potential investment, a company will generally take the risk of investment into consideration.

The anticipated risk of a project is the risk that an investment will not provide its expected return.

A company or investor will expect a higher rate of return from an investment if the risk of failing to see returns is high, and the risk premium accounts for this factor.

If the risk is expected to be high, a company will generally attach a significant risk premium based on the level of the anticipated risk.

For investments with low risk, the risk premium may be low, or none may be attached at all.

## Formula for Calculating the Hurdle Rate

The most common formula for setting the hurdle rate uses the weighted average cost of capital (WACC).

Using this number, the formula for calculating a company’s hurdle rate is:

Hurdle Rate = WACC + Risk Premium

A company may choose to account on additional factors as well, such as current interest rates or inflation, in arriving at a final hurdle rate.

## Using a Hurdle Rate

Hurdle rates provide a benchmark to use when evaluating possible investments.

This can be valuable for both companies and investors in determining whether or not to pursue an investment based on its financial value while eliminating possible biases caused by other factors.

In many cases, a company may set a company-wide hurdle rate in order to simplify making and comparing potential investment decisions such as launching new projects or purchasing new securities.

This can help ensure a minimum level of profitability before investing scarce capital.

For investors, the hurdle rate can help to meet retirement goals.

For instance, if based on an investor’s highest possible rate of saving, they would need a 5% rate of return on their investments to meet their retirement plans, then an investor would know that they need to ensure that their model portfolios create at least this hurdle rate in order to meet their goals.

Otherwise, they may need to revise their current retirement plans.

## Example of the Hurdle Rate

In order to better understand the hurdle rate consider this example of it in practice.

ABC Gizmo Producers is considering investing in a new production facility.

Based on its current estimates, it believes it can increase its sales significantly, creating a return of 10% per year from the new investment.

In order to decide whether or not to pursue the new investment, ABC Gizmo Producers set a hurdle rate for the new project.

The company calculated its WACC to be 5% and determined that the risk of not meeting its sales estimate is low, so it set a low-risk premium of only 2%.

This means that based on a WACC of 5% plus a risk premium of 2%, the hurdle rate for the project is 7%.

This means that the expected return of 10% from building a new production facility is greater than the hurdle rate and is, therefore, a sound investment.

### Advantages of Using the Hurdle Rate

• Clear Indicator of Profitability: The hurdle rate provides investors and managers a clear picture of the potential profitability of an investment or project. This can be useful for simplifying decision-making.
• Provides Objectivity: The hurdle rate removes potential bias from factors outside of profitability from the decision-making process. A hurdle rate accounts only for objective factors such as the risks involved and the cost of capital.

### Disadvantages of Using the Hurdle Rate

• Hurdle Rates Favor High Rates of Return: The hurdle rate is measured on a percentage basis and therefore favors high rates of return rather than the dollar value. This means that a company may favor projects that provide a lower total value in favor of those offering a high rate of return.
• May Not Be Accurate: One potential risk in calculating the hurdle rate is choosing an inaccurate risk premium. The risk premium is never a guaranteed number, and creating an inaccurate estimate can lead to an inefficient allocation of capital.

## Key Takeaways

• The hurdle rate is the lowest acceptable return required in order to pursue a particular investment or project.
• A hurdle rate may be higher on a project that poses a higher risk and lower for projects with greater certainty of return.
• A particular investor or company’s hurdle rate is often used in discounted cash flow analysis as the discount rate to find the net present value of an investment.
• For businesses, the weighted average cost of capital is often used as the hurdle rate.

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1. NYU Stern "The Weighted Average Cost of Capital" Page 1 . May 10, 2022

2. PennState "Investment, Strategy and Risk: Evidence from Hurdle Rates*" Page 1 . May 10, 2022