In capital budgeting, hurdle rate is the minimum required rate of return which businesses use as a benchmark to decide whether to invest in a project or not. A project must provide a return higher than the hurdle rate in order to be feasible for investment.
In the net present value analysis, hurdle rate is the discount rate used to find the present value of the net cash flows of the project. If the actual return on the project is higher than the hurdle rate, the net present value is positive and the project is accepted. In the internal rate of return analysis, if the IRR is greater than the hurdle rate, the project is accepted otherwise rejected.
Hurdle rate is also used in private equity and venture capital where it predominantly means the minimum required rate of return.
Hurdle Rate and WACC
Hurdle rate of a project is estimated based on a number of factors, the most important being the cost of capital of the company. Hurdle rate is often adjusted up and down based on the perceived riskiness of the project. If the risk inherent in a project is higher than the average risk, the hurdle rate is higher than the weighted average cost of capital (WACC) of the company and if the risk is lower, the hurdle rate is lower too.
Capital asset pricing model is applied to estimate the risk-adjusted hurdle rate for a project.
Hurdle Rate = Risk Free Rate + Project Beta × (Market Return – Risk free Rate)
Risk free rate is the rate on a risk-free investment. Return on long-term government securities provides a good approximation of the risk free rate.
Project beta is a coefficient that measures the riskiness of the investment. Higher beta means more risk and lower beta means lower risk. The project beta is typically calculated using the pure play method. In the pure play method, a public-listed company whose sole business matches the project being evaluated is selected and its beta is de-levered and re-levered to obtain an appropriate beta for the project.
Average return is the average return on all investments. It is approximated by the return on broad market index such as S&P 500.
You are a financial analyst at Jovan Arsen, Inc., a bus operator which is interested in bidding for a public transport project of a city government in a South Asian country. The project requires Jovan to purchase and operate buses on designated routes.
Following data is available:
- The company has to invest in 50 buses each costing $50,000 and operate it for 5 years. Total initial investment outlay is expected to be $3 million.
- The project has no salvage value.
- The city government has guaranteed to ply each bus for at least 50,000 kilometers at $1.75 per kilometer.
- The company’s variable costs are $1 per kilometer and its fixed costs are $250,000 per annum.
- Risk free rate is 5% and the company’s risk analyst has worked out the project beta to be 1.8. Return on the broad market is 10%.
- Weighted average cost of capital of the company is 8%.
- The country has offered full tax exemption.
We need to work out the net after tax cash flows for each of the five years of the project, which are calculated as follows:
Net annual cash flows = annual cash inflows – annual cash outflows
Annual cash inflows = rate/km ($1.75) × number of kilometers (50,000) × number of buses (50) = $4.375 million
Annual cash outflows = variable cost ($1) × number of kilometers (50,000) × number of buses (50) + fixed costs ($250,000) = $2.75 million
Net annual cash flows = $4.375 million - $2.75 million = $1.625 million
Net initial investment = $3 million
In order to do the NPV analysis, we need to discount the future cash flows. The hurdle rate to be used for discounting must be based on the risk inherent in the project. CAPM can be used to calculate the risk-adjusted discount rate to be used.
Hurdle rate = 5% + 1.8 × (10% - 5%) = 14%
The present value factor for 5 years annuity is 3.4331.
Present value of future net cash flows = 3.4331 × $1.625 million = $5.56 million
Net present value = present value of cash flows – initial investment = $5.56 million - $3 million = $2.56 million
Since the project has positive NPV at the given hurdle rate of 14%, the project should be accepted.