Economics
Hurdle Rate
Hurdle rate is the minimum rate of return that an investor expects to receive from an investment. It is used to determine whether an investment is worth pursuing or not. If the expected rate of return is lower than the hurdle rate, the investment is considered too risky and not worth pursuing.
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4 Key excerpts on "Hurdle Rate"
eBook - ePubFinancial Analysis
A Controller's Guide
- Steven M. Bragg(Author)
- 2012(Publication Date)
- Wiley(Publisher)
A company may choose to use several Hurdle Rates, depending on the nature of the investment. For example, if the company must install equipment to make its production emissions compliant with federal air quality standards, then there is no Hurdle Rate at all—the company must complete the work or be fined by the government. At the opposite extreme, a company may assign a high Hurdle Rate to all projects that are considered unusually risky. For example, if capital projects are for the extension of a current production line, there is very little perceived risk, and a Hurdle Rate that matches the cost of capital is deemed sufficient. If the capital expenditure is for a production line that creates equipment in a new market in which the company is the first entrant, however, and no one knows what kind of sales will result, the Hurdle Rate may be set a number of percentage points higher than the cost of capital. Thus, different Hurdle Rates can apply to different situations.Although the Hurdle Rate is the fundamental measuring stick against which all capital investments are evaluated, there is one exception to the rule: the payback period.PAYBACK PERIOD
The primary criterion for evaluating a capital investment is its ability to return a profit that exceeds a Hurdle Rate. However, this method misses one important element—it does not fully explain investment risk in a manner that is fully understandable to managers. Investment risk can be defined as the chance that the initial investment will not be earned back, or that the rate of return target will not be met. Discounting can be used to identify or weed out such projects, simply by increasing the Hurdle Rate. For example, if a project is perceived to be risky, an increase in the Hurdle Rate will reduce its net present value, which makes the investment less likely to be approved by management. Management may not be comfortable dealing with discounted cash flow methods when looking at a risky investment, however; they just want to know how long it will take until they get their invested funds back. Though this is a decidedly unscientific way to review cash flows, the author has yet to find a management team that did not insist on seeing a payback calculation alongside other, more sophisticated analysis methods.
eBook - PDF- Jack Broyles(Author)
- 2003(Publication Date)
- Wiley(Publisher)
The net result is that the firm will fail to achieve its potential for growth, and thus will not achieve maximum profit- ability. The result is loss of value for the shareholders. COMPROMISING FOR ADMINISTRATIVE CONVENIENCE One reason given for adopting a single Hurdle Rate for all projects is administrative convenience. Estimating the systematic risk of every individual project is not feasible. A better approach adopted by many companies is to assign risk-adjusted Hurdle Rates to risk classes rather than to individual projects. If a project falls into a particular risk class, then it is subject to the Hurdle Rate and the discount rate appropriate for that risk class. Figure 6.5 illustrates such a system, where risk classes A, B, C, and D represent classes of projects with successively higher risks and correspondingly higher required rates of return. While the risk classification approach is inexact, it is superior to using just one Hurdle Rate and represents a system that is administratively feasible and efficient. 7 PITFALLS IN PROJECT APPRAISAL 105 Figure 6.4 The Hurdle Rate and the Securities Market Line. 6 M. E. Rubinstein (1973) ‘‘A mean-variance synthesis of corporate financial theory,’’ Journal of Finance, Vol. 28, No. 1, 167–181. 7 A refinement of this system incorporating credit risk is in Chapter 13. DEFINITIONS Beta factor A measure of the market risk of an asset. The factor by which mean returns on the asset reflect returns on the market portfolio. Hurdle Rate Minimum acceptable rate of return for proposed capital projects. Securities Market Line (SML) Hypothesized linear relationship in the Capital Asset Pricing Model between the expected return on a security and its systematic risk. Systematic risk Risk that portfolio diversification cannot eliminate. 6-5 RISING RATES OF INFLATION ARE DANGEROUS RELEVANCE OF INFLATION TO INVESTMENT Inflating prices, alternating with infrequent shorter periods of declining prices, beset modern economies.
eBook - PDF- John A. White, Kenneth E. Case, David B. Pratt(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
Corporate Development and Business Finance units are responsible for appropriate use of the Hurdle Rate calculator: all Hurdle Rate calculations should be reviewed by the appropriate Corporate Development or Business Finance personnel before presentation to management, and a copy of the calculation is to be attached to each relevant economic analysis. Recognize that the relationship of a project’s estimated return to its Hurdle Rate is only one factor that is considered when accepting or rejecting that project. Other factors would include corporate initiatives, value of options created, health and safety, etc.’’ 7 6 From presentation materials shared with the authors by Brian Ferguson, chairman and chief executive officer, Eastman Chemical Company. 7 Ibid. FIGURE 4.8 Eastman Chemical Company Hurdle Rate (MARR) Calculator. 4-3 SPECIFYING THE MINIMUM ATTRACTIVE RATE OF RETURN 213 Eastman noted that the Hurdle Rate calculator is ‘‘a method to apply some level of rigor to address risk and uncertainty; a method to provide consistent application in a wide variety of projects across the company; and a method to provide a risk adjusted discount rate that appropriately levels the playing field for most EASTMAN projects.’’ It also noted what it is not: ‘‘an automated method to accept or reject projects.’’ 8 Eastman’s Hurdle Rate calculator asks the user to answer the following nine questions, with the indicated options for responses (percentages added to the base Hurdle Rate are shown in parentheses): 1. Is the project an acquisition of a publicly owned business? A. No (0 percent) B. Yes (1.5 percent) 2. What fraction of the project will be owned by Eastman? A. Less than 20 percent equity ownership (3 percent) B. At least 20 percent JV ownership, without Eastman having control (2.5 percent) C. At least 35 percent JV ownership, without Eastman having control (2 percent) D. At least 50 percent JV ownership, without Eastman having control (1.5 percent) E.
eBook - PDF- Timothy Mayes(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 11 The Cost of Capital 342 Knowledge of a firm’s cost of capital is vital if managers are to make appropriate decisions regarding the use of the firm’s funds. Without this knowledge, poor investments may be made that actually reduce shareholder wealth. In this chapter, you will learn what the cost of capital is and how to calculate it. The Appropriate “Hurdle” Rate A firm’s required rate of return on investments is often referred to as the Hurdle Rate because all projects must earn a rate of return high enough to clear this rate. Otherwise, while the project may earn an accounting profit (covering its operating and interest costs), it may not earn enough to cover its cost of equity. It will, therefore, earn a negative economic profit and reduce shareholder wealth. But what is the appropriate rate to use when evaluating investment opportunities? Let’s look at an example: The managers of Rocky Mountain Motors (RMM) are considering the purchase of a new tract of land that will be held for one year. The price of the land is $10,000. RMM’s current capital structure is 40% debt, 10% preferred stock, and 50% common equity. Because this capital structure is considered to be optimal, any new financing will be raised in the same proportions. RMM must raise the new funds as shown in Table 11-1. Before making the decision, RMM’s managers must determine what rate of return will simultaneously satisfy all of their capital providers. What is the minimum rate of return that will accomplish this goal? Looking at the third column of Table 11-1, it is clear that the total financing cost is $980. So, the project must generate at least $980 in excess of its cost in order to cover the financing costs. This represents a minimum required return of 9.8% on the investment of $10,000.
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