Hurdle Rate: Definition And How To Calculate It

Investing is all about weighing risks and rewards, and deciding whether your risk tolerance and finances work for certain investment options. Using the hurdle rate can help you calculate the expected rate of return you need for an investment to be worth the risk.

Like any investment tool, using a hurdle rate has its pros and cons. That’s why it’s important to understand what it is — including the formula used to calculate it — and how to evaluate whether it’s a useful tool for you.

What Is A Hurdle Rate?

How A Hurdle Rate Works

Hurdle rates are important for businesses when determining whether to invest in future projects. Also referred to as the break-even yield, a hurdle rate looks at whether a project is considered a sound investment.

Using a hurdle rate is meant to offer a neutral look at investments so that there is less bias as to whether a project should move forward. Businesses use financial modeling, such as listing out revenue, expenses, and capital cost in order to come up with a forecast, to determine the figure.

To evaluate the viability of a project, businesses can compare the hurdle rate to a few different metrics like: the net present value (NPV) and internal rate of return (IRR). The first method uses a discounted cash flow (DCF) analysis, where a business will decide the minimum rate of return that's needed in order to move forward with an opportunity or project. If the NPV is positive after subtracting the hurdle rate, in most cases businesses will choose to give the go-ahead.

The IRR method is also used to compare against the hurdle rate. A project is most likely viable if the IRR is higher than the hurdle rate.

Key Factors That Determine Hurdle Rate

Since the hurdle rate is a main factor when determining whether a project is viable, it's important to set it at a rate that won't potentially hinder profitable ventures and risk taking on unprofitable ones.

As in, a too high of a hurdle rate could shut out too many opportunities, and a hurdle rate that’s too low could increase the risk of unprofitable projects.

Some key factors businesses use to determine hurdle rates include:

• Risk premium: When you invest, there’s always a chance that you could lose capital – a positive rate of return isn’t guaranteed. This factor determines a risk value for any anticipated risk that may be involved. Less risky projects usually have smaller hurdle 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.
• Cost of capital: This is a company’s cost of borrowing money. The higher the cost, the more risky the investment could be.
• 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%. The higher the rate of return, the more it could be worth it to invest.
• Inflation rate: Depending on the current inflation rate, you may need to increase the final hurdle rate to account for risk. Inflation may even be one of the most important factors if inflation rates are high.

How To Calculate The Hurdle Rate

Calculating the hurdle rate uses a fairly straightforward formula:

Hurdle rate = weighted average cost of capital (WACC) + risk premium

The weighted average cost of capital (WACC) is a blended calculation of a company’s equity and debt. More specifically, the WACC is the average rate that a business can use to pay its assets and is calculated by taking the average from their post-tax cost of capital — think debt, common stock, and preferred stock.

A company’s risk premium is the anticipated amount of risk that may be involved. It’s calculated by subtracting the risk-free rate of return from the estimated rate of return. For example, if a project is expected to yield a 10% return if everything goes smoothly, but the minimum ( “risk-free”) rate of return for the project overall is 3%, the risk premium would be 7%.

Hurdle Rate Example

Khalia’s Fashion Factory wants to evaluate whether buying a new clothing machine is a good investment. The business estimates that purchasing this machine might result in a 20% increase in sales. The WACC is 12% and the risk premium is 3%.

Given the information above, here’s how to calculate the hurdle rate:

Hurdle rate = WACC + risk premium

12% + 3% = 15%.

Therefore, the hurdle rate is 15%.

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

Hurdle Rate Limits

While the hurdle rate can be a useful tool in assessing risk in an investment opportunity, there are some limitations. A main limitation is that the hurdle rate typically favors projects that have a higher projected return expressed as a percentage, rather than considering the actual profits available.

For example, say your company has 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%, equating to $10 million in profits.

Basing a decision solely on the hurdle rate in the above scenario could cause you to overlook the potential opportunity of the second project simply because the first opportunity offers a 30% return.

Plus, the expected return used is only an estimate — it’s difficult to be certain about this calculation. If you invest in a project, there’s no guarantee that your actual return will be higher than the hurdle rate.

The Bottom Line

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.

Before you start investing, you should have a good idea of where your money goes each month. Download the Rocket Money^SM app to get a full picture of your finances so you can invest with confidence.