Watch this scene carefully from the movie Milkha Singh. This is a scene where Milkha Singh (played by Farhan Akhtar) is being asked by his coach to keep running. He is being trained and he needs to clear a certain timing (benchmark) before he can create a world record and his coach is happy. This Learning Perspectives blog will explore the meaning of hurdle rate.
What is Hurdle Rate?
Generally, companies take up new projects only when the project passes the hurdle rate (HR). As the name suggests, it is the benchmark the company creates to analyze to either accept or reject the proposal. It is important to mention capital budgeting in this context as capital budgeting means identifying and selecting the best project that will earn the most benefit to the company. Techniques to calculate capital budget are Net present value (NPV), Internal rate of return (IRR), payback period, etc.
The hurdle rate is also the cost of capital. Capital structure impacts the cost of capital. Capital structure is the combination of debt and equity in a company. Each project’s HR should reflect the risk of the project, not the risk associated with the firm’s average project.
WACC or the weighted average cost of capital is used to evaluate the cost of most projects. The Hurdle Rate is the minimum rate that the company would earn when the company invests in a project.
In a construction company, there could be two projects such as constructing a mall or constructing a parking space. For the company to decide which project would be more beneficial in the future it identifies a hurdle rate. This helps the company in reaching a viable conclusion in the form of selecting the project which gives the most benefit.
Under the NPV or the net present value, the hurdle rate is defined as the discount rate through which we discount the future cash inflows. If the actual rate of return is greater than the Hurdle Rate, the project is accepted otherwise rejected.
The Hurdle Rate is often adjusted according to the riskiness of the project. It is either adjusted up or down depending on the risk factor. CAPM or the capital asset pricing model is used to determine the risk-adjusted hurdle Rate.
HR= Rf+ Beta(Rm-Rf),
i.e. Rf= risk-free rate, Rm = Market risk, Beta= calculates the riskiness of the project.