Hurdle Rate

A hurdle rate is the minimum rate of return that a proposed project or investment must be expected to earn for a company or investor to go ahead with it. Projects whose expected return clears the hurdle are considered acceptable; those that fall short are rejected or sent back for rework. In corporate finance the hurdle rate is the threshold used in capital budgeting decisions, while in private equity and hedge funds the term also describes the return a fund must deliver to investors before the manager earns a performance fee.

The hurdle rate reflects the opportunity cost of money: by investing in one project, a company gives up the return it could have earned elsewhere at similar risk. For this reason it is usually set at or above the company's cost of capital, with extra allowance for risk.

Most companies start with their weighted average cost of capital (WACC), which blends the after-tax cost of debt and the cost of equity in proportion to how the company is financed. The cost of equity is often estimated with the capital asset pricing model. A simple way to express the hurdle is:

Here $\text{WACC}$ is the company's overall cost of capital and $\text{Risk premium}$ is an extra margin for the specific risks of the project, such as entering a new country, using unproven technology or depending on a single customer. A company with a WACC of 8 percent might set a hurdle of 8 percent for routine equipment replacement, 11 percent for expanding an existing product line and 15 percent or more for a venture into a new market. Using different hurdles for different risk levels prevents a company from treating a risky project the same way as a safe one. The size of the extra margin is related to the concept of a risk premium in markets.

The hurdle rate is applied in two common ways. With the internal rate of return method, a project is accepted if its IRR exceeds the hurdle. With net present value, the hurdle is used as the discount rate, and a project is accepted if its NPV is positive.

Consider a manufacturer evaluating a $1,000,000 machine expected to produce after-tax cash flows of $300,000 a year for five years, against a hurdle rate of 10 percent. The present value of the cash flows at 10 percent is about $1,137,000, so the NPV is about $137,000 and the project passes. Its IRR is about 15.2 percent, comfortably above the hurdle. If the company instead applied a 16 percent hurdle because the machine serves a volatile market, the NPV would turn slightly negative, at about negative $18,000, and the project would fail.

In private equity and some hedge funds, a hurdle rate, often called the preferred return, is a minimum annual return the fund must deliver to its limited partners before the general partner can share in profits through carried interest. A common figure in private equity is 8 percent a year. If the fund returns less, the manager receives only the management fee. Many funds include a catch-up clause so that once the hurdle is cleared the manager quickly receives its full share of profits.

Setting the hurdle rate is partly a matter of judgment, and errors in either direction are costly. A hurdle that is too high causes a company to reject good projects and underinvest, which surveys suggest is common, since many firms use rates well above their actual cost of capital. A hurdle that is too low lets value-destroying projects through. Using a single company-wide rate for all projects tends to favor risky projects and penalize safe ones. Hurdle rates should also be reviewed when interest rates change, since the cost of capital moves with them. Finally, managers who know the hurdle may inflate their cash flow forecasts to clear it, so many companies combine hurdle tests with post-investment reviews, and some compare results against the simpler accounting rate of return.