Also known as the minimum acceptable rate of return, a hurdle rate has to do with potential investment evaluation and return rates. If an expected rate of return is above the hurdle rate, the investment is generally considered sound. But just what is a “hurdle rate?” That and more are covered below.
In investing, a hurdle rate is the minimum rate of return necessary for an investor to proceed with a project. The rate is determined by evaluating risk, capital costs, existing opportunities for business growth, rates of return for similar investments, and other factors.
Note that the cost of capital is the implied rate of return (IRR) that a company anticipates on its assets, without the effect of debt.
A risk premium, often assigned to a prospective investment, represents the expected amount of risk involved. The higher the risk, the higher the likely premium, based on the premise that the risk is of losing money, the higher the return should be. In other words, “risk” is the primary “hurdle” an investment must surmount to be worth it.
Companies usually add what is known as a risk premium – called a weighted average cost of capital (WACC) — to the overall required return and use that as their hurdle rate.
For example, say that Mike’s Yard Goods is aiming to buy a new lathe. The company surmises that with this new piece of machinery, it can increase its sales of specially made wooden products, resulting in an investment return of 11 percent. The company’s WACC is 5 percent and the risk of not selling these seasonal products is minimal, so a low-risk premium of 3 percent is assigned. Thus, the hurdle rate is:
WACC (5 percent) + Risk Premium = 8 percent.
With an eight percent hurdle rate and an expected investment return of 11 percent, buying the new machinery would be considered a good investment.
Some companies select an arbitrary hurdle rate to discount cash flows to get to the project’s net present value (NPV). Typically, if the NPV is positive, the project is approved.
In general, employing a hurdle rate to gauge an investment’s prospects helps to avoid any bias created by any project preference. Assigning a risk factor allows the investor to utilize the hurdle rate to show whether the project has any financial promise, any assigned intrinsic value notwithstanding.
For instance, a company that had a 10 percent hurdle rate for project acceptance would likely take on a project with an IRR of fourteen percent and no major risk. Also, discounting the project’s future cash flows by that ten percent hurdle rate would result in a substantial and positive NPV, and likely project acceptance as well.
The most common way to employ the hurdle rate to assess an investment is by conducting a discounted cash flow analysis. Such an analysis uses the concept of time value of money to forecast future cash flows and subsequently discount them back to existing values to get the NPV. This first requires financial modeling on the part of the company.
Prime considerations when it comes to hurdle rate include:
The most common formula for calculating the hurdle rate is Cost of Capital + Risk Premium = hurdle rate. So, if an investor’s cost of capital equals five percent, and the risk premium for a certain investment is three percent, the hurdle rate would be eight percent (three percent plus eight percent).
Say, for example, that Company ABC is considering investing in a new plant. It expects that, with the enhanced capacity, it can heighten sales, resulting in an eight percent annual return. Its WACC is four percent, meaning that investors anticipate profits of four cents on the dollar. The company is at low risk of anemic sales from increased production, setting that premium at two percent.
Therefore, WACC (four percent) + Risk Premium (two percent) = a hurdle rate of six percent.
Because Company ABC anticipates the new factory will produce a higher rate of return, it can invest with confidence.
Both should be considered when taking on an investment but the two can be inversely related. In other words, while a hurdle rate can be low, an investor may believe that means the NPV is high. However, that is not always necessarily the case.
As with most anything, there are limitations when it comes to hurdle rate:
Hurdle rates could actually be lower with a diversified investment portfolio, which can decrease overall risk since asset classes are varied. If a portion of one’s holdings are underperforming, another has a chance to do better. In fact, portfolio diversification is essential to successful investing.
Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments.
This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.
However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.
Even with its limitations, the hurdle rate can be an important factor in guiding investment decisions. Note that the rate also can be used with alternative investments, which can also serve to diversify portfolios and decrease overall risk.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.