What is the 'hurdle rate'?

The hurdle rate is the minimum rate of financial return that investors expect to receive on an investment.

It is determined by evaluating the cost of capital, the risks, and opportunities regarding business expansion.

The use of hurdle rates has one goal: the average return on a company's investments should not be lower than the average cost of capital.

Furthermore, it allows companies to make important decisions regarding the feasibility of pursuing a specific project.

Based on the level of risk, the hurdle rate adjusts to the present level of risk:

• More risky projects: have higher hurdle rates;
• Less risky projects: have a lower hurdle rate.

It is important to assess all risks in order to associate your specific rate.

How a hurdle rate is determined

Most companies use the (WACC) which stands for Weighted Average Cost of Capital.

It is one of the most employed rates for evaluating a company's value and is also used as the minimum rate for investments.

Companies can repurchase their own shares as an alternative to a new investment, and they would likely earn their WACC as a return rate.

In this way, if you invest your shares and earn your WACC, you could have the opportunity cost of any alternative investment.

Furthermore, it is important to know that any project in which the company invests must be equal to or greater than its cost of capital.

For example, if a company has a WACC of 12% and half of its assets are in a state with high risk and the other half are in another state where there is low risk, when evaluating a new investment, it should not use the same minimum rate to compare them.

Instead, it should use a higher rate for the investment with high risk and a lower one for the investment with low risk.

Hurdle Rate Strategies

When considering a potential investment, a company must first perform an assessment to check if a project has a positive present value.

It's important not to set the rate too high so as not to hinder other profitable projects that could favor short-term investments over long-term ones.

To set a hurdle rate it's important to consider:

• Risk Premium: assigning a value for the risk of the project;
• Inflation Rate: which could affect the final rate by 1%-2%;
• Interest Rate: an opportunity cost earned on another investment, hence any minimum rate must be compared with actual interest rates.

In conclusion, we must not forget that a low hurdle rate might also translate into an unprofitable project.