Are you pondering a potential investment or upcoming project? Hurdle rate offers one way to measure risk vs. reward and determine if it’s worth your time. Here’s a closer look at what a hurdle rate is, and how it works.
Hurdle rate explained
The definition of hurdle rate is the minimum required rate of return on a financial proposition for it to receive the green light. This hurdle rate concept can be applied to investments and business projects. The greater the risk involved in an investment, the higher the hurdle rate will be. It’s also called the break-even yield. There are several ways to calculate hurdle rate, including using the weighted average cost of capital (WACC) and net present value (NPV) as part of a discounted cash flow analysis.
For example, in the case of a discounted cash flow analysis, cash flows are discounted using a set rate. This refers to the minimum rate of return needed for a project – in other words, the hurdle rate.
Here are a few factors involved when calculating hurdle rate:
Current expansion opportunities
Rates of return for similar projects
Cost of capital
The particulars and method used will naturally depend on the type of investment. Calculating the internal rate of return is another way to determine hurdle rate. For a project to go forward, the internal rate of return should be greater than or equal to the hurdle rate.
Hard vs. soft hurdle rate
Investors often talk about a hard hurdle rate, soft hurdle and blended hurdle.
Hard hurdle rate: This is when profits are calculated above the hurdle rate.
Soft hurdle rate: This is calculated on all profits only when the hurdle is achieved.
Blended hurdle rate: This approach combines the two, calculating all profits when the hurdle is achieved. However, it doesn’t allow investors to drop below the hurdle rate when calculating return.
How to calculate hurdle rate
There are a few methods to choose from when looking at how to calculate hurdle rate. One is to use the WACC, as we’ve mentioned above. With the WACC, companies have the option of buying back their own shares, earning the WACC as a rate of return. Considerations for any hurdle rate calculation should also include:
Inflation rate: The final return may be inflated depending on the economic conditions, which should be worked into the anticipated hurdle rate.
Interest rate: You should compare hurdle rates to real-life interest rates to see if more money could be earned on another real-world investment.
Risk premiums: You can assign a value to the risk involved with any investment or project.
If you decide to calculate hurdle rate using a discounted cash flow analysis, you should first model all of the project’s potential revenues, expenses, and associated costs in a spreadsheet to create a forecast.
This will include cash flows over the lifespan of the investment. Discount these back to present day to calculate net present value. If the NPV is higher than zero, the project has met its minimum hurdle rate.
Pros and cons of using the hurdle rate
The hurdle rate offers some distinct advantages for investors. It provides a clear-cut vision of whether or not the investment will be profitable, using factors like risk premiums and net present value as its basis.
However, there are limitations to using the hurdle rate. It doesn’t present the full picture of potential returns, because it only shows you percentages rather than dollar values. If you’re using the hurdle rate as your only decision-making factor, you might miss out on more valuable projects with greater profit in AUD but lower hurdle rates.
This is why, as with any forecasting tool, hurdle rate should be used in conjunction with other modelling techniques before making final decisions.
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