Calculating Hurdle Rates for Investments

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Hurdle rate is a term describing the minimum return an investor requires before deciding to buy a security or make another type of investment. It is expressed as a percentage. That is, if an investment promises to provide a return that equals or exceeds the hurdle rate, the investor may decide to go ahead with it. An investment that offers a return below the hurdle rate is unlikely to be pursued. Use of a hurdle rate has some limitations and may not be the only consideration an investor looks at, but it is widely used when selecting investments.

A financial advisor can help you more accurately calculate and assess an opportunity’s hurdle rate than if you worked alone.

The hurdle rate is also called the minimum acceptable rate of return, the required rate of return or the target rate. In addition to investors evaluating securities, business managers budgeting for capital expenditures use the hurdle rate to decide whether to pursue projects such as developing new products or entering new markets. When doing so, they sometimes refer to it as an internal rate of return (IRR). If a proposed project can’t produce an IRR higher than the hurdle rate, the proposal is dead in the water.

Hurdle Rate Factors

In order to come up with the hurdle rate they will use to assess investment opportunities, investors will focus on the following two factors:

• Cost of capital. This is what the investor would have to pay to borrow or otherwise obtain the money that will be used to fund the investment. It may be the same as the prevailing interest rate on loans.
• Risk. This considers the level of risk that the investment will not pay off. An investor will want a risk premium – a higher rate of return – on an investment that carries more risk.

In addition, depending on the situation an investor may consider these additional factors when figuring the hurdle rate:

• Alternative investments. An investor is likely to have many investment opportunities, so even if an investment is likely to beat the hurdle rate, in order to be approved it may also have to exceed the returns promised by other investments.
• Inflation rate. In long-term investments, the rate of inflation may also be included in calculating the hurdle rate.
• Base rate of return. This is generally considered to be the interest rate that is offered on a risk-free investment such as a 10-year Treasury bond.

Calculating Hurdle Rate

The basic hurdle rate formula is straightforward. To calculate hurdle rate an investor starts with the cost of capital and adds the risk premium that is necessary to adjust for the possibility that the investment will not be successful.  Here is the formula: Cost of capital + risk premium = hurdle rate. For example, if an investor’s cost of capital is 5%, and the risk premium for a specific investment is 3%, the hurdle rate would be 5% plus 3% or 8%.

In this case, the investment under consideration would have to offer a return of 8% or better in order to clear the hurdle rate. If the investment offered a return of only 6%, the investor might decide not to go further.

Hurdle Rate Limits

Hurdle rates can help bring a degree of objectivity to making investment decisions. It helps investors avoid being overly influenced by more subjective factors such as an appealing narrative about a particular stock. However, hurdle rates also have some limitations.

For one, calculating the risk premium is an inexact science. There is no way to be certain in advance what the chances are that an investment will be unsuccessful. While the risk premium may be given as a precise percentage, in reality it is not much more than an educated guess.

Another significant issue with using a hurdle rate is that it may cause an investor to pass over investments that could provide greater profits in favor of high-percentage returns. For instance, an investment of a very large amount of money can generate higher profits than a smaller investment, even if the smaller investment has a higher percentage return.

For these reasons, hurdle rates are just one consideration used when evaluating investment opportunities.

Bottom Line

The hurdle rate is a tool to evaluate whether an investment is worthwhile. It takes into account the cost of capital and the level of risk an investment carrier and sets a minimum acceptable rate of return.  However, it’s difficult to calculate risk accurately, and there’s sometimes a tendency to over-emphasize high-percentage investment opportunities over those that may offer lower percentage returns but higher overall profits. If it’s set too high, perhaps because of an excessively large risk premium, it could cause an investor to pass; if it’s set too low, an investor may be investing too conservatively and missing available profits.