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What is a Hurdle Rate? - Definition & Formula

Instructor: Brendan Verma

Brendan was a Financial Advisor for 10 years and has completed all 3 levels of the CFA Program.

Hurdles can be hard to cross sometimes, but they aren't always the kind you need to jump over! In this lesson, we will examine the concept of a hurdle rate and how companies use it to make informed decisions.

Making investment decisions

ABC Inc. is a stable growth company, that has been successful in delivering consistent returns to its shareholders through predictable cash flows. How have they achieved this? The management team at ABC Inc. is skilled at picking profitable projects to invest in, and as they consider new avenues for investment each year, they focus on a thorough comparison of the alternatives. Evaluating each project on its own merit is vital to their process of making a fair comparison. They hold this view because the returns and uncertainty associated with projects varies considerably.

Let's look at how they use the concept of a hurdle rate in their evaluation.

What is a hurdle rate?

A wise man once said, ''If you don't cross the hurdle, you don't get to the other side!'' Seems logical, right? It sure is, and the same principle applies in corporate finance. When companies evaluate projects, they set a rate that the projects must earn before they can be considered viable options. In a manner of speaking, the prospective projects must clear the 'hurdle rate'.

You may also encounter the term hurdle rate in the context of hedge funds. Here it indicates the minimum rate of return a hedge fund needs to produce before it can earn a performance fee. In this lesson; however, we will focus on the use of hurdle rate in corporate finance.

How is it calculated?

A hurdle rate usually consists of 2 elements:

  1. The company's cost of funds/cost of capital (which is usually the WACC, or weighted average cost of capital)
  2. A risk premium that depends on the riskiness of a project.

Here's the formula for calculating a hurdle rate:

  • Hurdle rate = WACC + risk premium (to account for the risk associated with a projects cash flows)

Let's say the cost of funds for ABC Inc. is 7% p.a. when evaluating projects. Managers at ABC Inc. would add a risk premium, say 4% p.a. for projects with more uncertain cash flows, while only adding 0.5% p.a. for projects that have predictable and less risky cash flows. This would yield a hurdle rate of 7% + 4% = 11% p.a. for risky projects and 7% + 0.5% = 7.5% p.a. for low risk projects.

By adding a risk premium to the cost of capital (WACC) in determining the hurdle rate, the managers of ABC Inc. can make a fair comparison between projects. Just because a low risk project does not look as attractive on paper due to smaller potential cash flows, does not make it an unworthy selection. After including risk in the equation, the manager may well find that the low risk project is actually expected to yield a higher net present value.

How is it used?

The hurdle rate can be used in two ways:

To discount the projects cash flows in determining a net present value

Net Present Value = Present value of a projects net cash flows (discounted by the hurdle rate)

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