What is Hurdle Rate: Definition, Examples and More

Investors need a marker to calculate the minimum return of any investment- that is where the “hurdle rate” comes into play. But what is hurdle rate? A hurdle rate represents the minimal appropriate price of return that investors use for assessing the profitability of any potential investment.

Generally, a decrease in hurdle rate indicates a much less volatile investment, probably resulting in lower returns. Investing in a venture can become a worthwhile venture if the predicted return surpasses the hurdle fee.

Conversely, riskier investments necessitate a higher hurdle rate. To offset extended risks, funding possibilities below consideration have to ideally provide a better expected go back. In essence, comprehending the hurdle fee serves as a means to evaluate the viability of funding for a person.

How to Calculate the Hurdle Rate

The hurdle rate formula depends on the cost of capital and risk premium. 

Hurdle Rate= Weighted average cost of capital + Risk premium

Let’s see how these two make up “what is hurdle rate”.

Weighted Average Cost of Capital (WACC): This is a calculation that determines the cost that the company incurs in order to obtain the capital. It represents the amount that the company must repay to its investors for each rupee that it raises. In simple words. It is the cost to raise money after accounting for debt and taxes. 

Risk Premium: To understand “What is hurdle rate?” you need to understand the risk premium that accounts for the potential failure of the investment. You can calculate it by subtracting the return on a risk-free investment. For instance, if company ABC had a return of 9% and the recommended India ERP is 7.50%.

So, are wondering what is a hurdle rate in finance as an example? Find out below. 

Example 1 of Calculating What is Hurdle Rate

If an investor’s cost of capital is 7% and the risk premium for a specific investment is 4 per cent, the hurdle rate would be 11 per cent.

Weighted Average Cost of Capital (WACC)+ Risk premium= Hurdle rate

Example: 7 + 4% = 11%

Remember that the inflation rate can affect the calculator of the hurdle rate as it reduces the purchasing power of money. The RBO sets the interest rate changes which can also impact the risk-free rate which experts use to calculate the risk premium.

Example 2 of Calculating Hurdle Rate

After grasping the fundamentals, formula, and calculation of the finance hurdle rate, let’s apply this theoretical understanding through the following example.

Consider XYZ Ltd., where the cost of capital is 8% annually. Managers add a 5% risk premium for uncertain cash flow projects and 0.5% for less risky ones. The Hurdle Rate is thus 13% for risky projects and 8.5% for less risky ones, aiding in project comparison for investment decisions. 

Despite a low-risk project appearing less lucrative initially, the added risk premium may reveal a higher Net Present Value (NPV), making it a worthwhile investment.

This is how the hurdle rate works. But how does the hurdle rate differ from the WACC? Let’s see.

Hurdle Rate vs WACC

Hurdle rate refers to the minimum acceptable rate of return for a specific investment, reflecting its dangers. In evaluation, the Weighted Average Cost of Capital (WACC) is the average rate of return a agency is expected to pay to all its stakeholders, weighted through the usage of their respective contributions. Both metrics guide investment decisions and assess financial viability.

In lieu of this discussion about hurdle rate,we also need to know the difference between hard and soft hurdle rates.

Hard Hurdle Rate vs Soft Hurdle Rate vs Blended Hurdle Rate

Hard Hurdle Rate	Soft Hurdle Rate	Blended Hurdle Rate
This happens when you calculate the profit over the hurdle rate.	You calculate this on all profits only when the hurdle is achieved.	This is the combined approach of the previous two. It calculates all the profits once you achieve it. However, it does not allow investors to drop below the hurdle rate when they calculate the return.

Now that you have learned the answer and the concept of the “What is hurdle rate?” question, let’s see the factors to consider.

Factors for Settling a Hurdle Rate 

For analysing a potential investment, a company first needs to hold a preliminary evaluation. This evaluation will assess if the project has a positive net present value. 

To analyse a potential investment, a company must first hold a preliminary evaluation to assess if the project has a positive net present value. 

• Inflation Rate: Mild inflation in the economy can impact the final rate by 1%-2%. In some cases, inflation might be the paramount factor to consider.
• Risk Premium: Determining the risk associated with a project and assigning a corresponding value. Typically, riskier ventures demand higher hurdle rates compared to less risky ones.
• Interest Rate: Reflecting the opportunity cost of potential earnings on alternative investments, interest rates influence hurdle rates and must be compared to real interest rates.

And to answer the last part of the question- “what is hurdle rate?” We need to understand how to use it and how it works. Let’s see.

How to Use the Hurdle Rate and Why Is It Important?

The significance of the hurdle rate for businesses lies in providing an objective means to assess investments and prevent decisions influenced by non-financial factors. 

It serves as a benchmark for management teams and private equity firms evaluating potential investments, aiding in discounting cash flows and calculating net present value. 

In acquisitions, the hurdle rate helps determine the favourable difference between the acquirer’s rate and the target company’s cost of capital and risk premium. Investors can also use the hurdle rate to gauge risk levels, with the rate increasing proportionally to the investment’s risk level, necessitating a higher risk premium. 

FAQs: What is Hurdle Rate: Definition, Examples and More 

 Who sets the hurdle rate?

The employer’s management or monetary decision-makers set the hurdle rate for a certain investment. It reflects the corporation’s fee of capital and hazard tolerance, guiding investment decisions.

Do macroeconomic factors influence the hurdle rate?

Yes, macroeconomic factors like inflation, interest rates, and economic stability can influence the hurdle rate. Changes in these factors can also affect the cost of capital and chance considerations.

What is the hurdle rate of renewable energy in India?

The hurdle rate for renewable energy projects in India varies but often aligns with industry standards, factoring in project-specific risks, value of capital, and potential returns.

How does the hurdle rate impact project evaluation?

Projects that have expected returns above the hurdle rate are acceptable. However tose that are below the hurdle rate get rejected. This rate helps companies prioritise  investments by focusing on those with the potential to meet or exceed the required rate of return.

Conclusion

Knowing “ what is hurdle rate? ”is crucial as it is a vital metric for buyers and businesses to assess the viability of capability investments. It serves as a benchmark for assessing profitability and hazard, with a lower charge indicating a much less volatile funding. To recognise more about the intricacies of funding go to Sustvest.