Hurdle Rate: Definition, Calculation & Investment Uses

Before making an investment in a project or company, it’s a good idea to evaluate the potential risks and rewards. One way to do this is to use the hurdle rate. It’s an investment tool you can use to calculate the expected rate of return you need for an investment to be worth the risk.

However, like any investment tool, using a hurdle rate has its pros and cons. Keep reading to learn what those are, the formula used to calculate it and how to use it.

What Is A Hurdle Rate?

A hurdle rate is the minimum rate of return an investor or company should accept when evaluating a potential investment. It’s used to judge whether investing in a project is a smart decision. If the expected return is greater than the hurdle rate, deciding to invest in a project could be a wise move.

The riskier the investment, the higher the hurdle rate will be. To compensate for the higher risks, the project you’re investing in should have a greater expected return.

How Do You Determine Hurdle Rate?

Before you invest in a project, you should review it to see if it has a positive net present value (NPV). This involves performing a discounted cash flow analysis.

 

If the NPV is a positive number, this means the project’s expected rate of return exceeds the hurdle rate. However, if it’s a negative number, the investment might not be worth the risk.

In addition, you’ll need the weighted average cost of capital (WACC). This is a combined measurement of a company’s equity and debt.

 

 

Hurdle Rate Key Factors

While using the hurdle rate, here are some factors to keep in mind:

 

• Risk of investment: When you invest, there’s always a chance that you could lose capital – a positive rate of return isn’t guaranteed.
• Rate of return: Your rate of return is a measurement of how much an investment earns or loses expressed as a percentage. For example, imagine you purchase $10,000 of a company’s stock and it grows to $15,000, your rate of return is 50%.
• Cost of capital: This is a company’s cost of equity or borrowing money.
• Interest rates: To calculate a project’s risk premium, you can compare your expected rate of return against the U.S. treasury bill’s interest rate. Since this financial product is backed by the government, it is commonly used as the “risk-free” rate.

Pros And Cons Of Using Hurdle Rate

Like most investment tools, the hurdle rate comes with certain advantages and disadvantages.

Hurdle Rate Advantages

Using a hurdle rate to evaluate an investment can give you an idea of whether your investment will be profitable. Instead of making a decision based on the popularity of a project, it provides a way to evaluate an investment opportunity based on finances.

Hurdle Rate Disadvantages

There are a few disadvantages of using the hurdle rate. The main disadvantage is that it typically favors projects that have a higher projected return expressed as a percentage.

For example, pretend you have to choose between investing in two projects. The first project promises an estimated rate of return of 30%, which equals $5 million in profits. However, the second project has an expected rate of return of 15%, which equals $10 million in profits.

Basing a decision solely on the hurdle rate in the above scenario could cause you to overlook the potential opportunity cost of not choosing the second project.

Another disadvantage is that the expected return used is only an estimate. If you invest in a project, there’s no guarantee that your actual return will be higher than the hurdle rate.

Hurdle Rate Formula

To find the hurdle rate, you can use the following formula:

 

WACC + risk premium = hurdle rate

 

The weighted average cost of capital (WACC) is a blended calculation of a company’s equity and debt. And risk premium is calculated by subtracting the risk-free rate of return from the estimated rate of return.

Hurdle Rate Example

To illustrate how this works, let’s pretend that Khalia’s Fashion Factory wants to evaluate whether buying a new clothing machine is a good investment. It estimates that purchasing it might result in a 20% increase in sales. The WACC is 12% and the risk premium is 3%.

Given the information above, the hurdle rate is 15% (12% + 3%).

Since the estimated return on investment (20%) is greater than the hurdle rate (15%), purchasing the new clothing machine could be a good idea.

The Bottom Line: Understand Hurdle Rate If You’re An Investor

A hurdle rate is the lowest rate of return you should expect when investing money in a project or company. It’s used to calculate the rate of return you need to break even on an investment or generate a positive return.

The main advantage of using the hurdle rate is that it can help you decide whether to pursue an investment. However, a major downside is that using it tends to favor projects with high estimated percentage returns over potential profit in dollars.

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