Hurdle Rate (Finance) Definition
A hurdle rate, also called a break-even yield is the minimum acceptable rate of return on investment (ROI) that is mandated by an investor or a fund manager as a form of compensation for the risks undertaken because of making that investment. As a rule of thumb, the higher the risks undertaken, the higher is the hurdle rate.
In high-risk investments such as hedge funds, investors actually make it mandatory for fund managers to beat hurdle rates in order to be eligible to collect incentive fees.
A Little More on What is a Hurdle Rate
A hurdle rate is an effective comparison tool that pitches the merits of the investment in question against the associated risks in order for the investor or fund manager to be able to decide whether or not to proceed with the investment. A sound investment will always have a return on investment higher than the hurdle rate. An ROI below the hurdle rate will obviously thwart the investor from making that investment, saving him/her from potential loss. This kind of rate of return predictions for investments comes in handy during capital budgeting, where important investment decisions are taken based on calculations of internal rate of ROIs of proposed investments.
Example of How to Use a Hurdle Rate
Every asset carries with it a risk premium, which is a value that indicates the estimated amount of risk associated with a potential investment. By the rule of thumb, the higher the risk, the higher is the risk premium, and vice versa.
It is but natural human behavior for investors to sometimes be biased toward a project that may seem lucrative at first glance. Applying a hurdle rate to assess underlying risks and pitching them against potential gains can greatly assist in making a final decision regarding whether or not to go ahead with the investment.
Let us assume a business mandates a standard hurdle rate of 15 percent for a new undertaking. Given that a new venture has an internal rate of return of investment of 20 percent, the business will, in all probability go ahead with the investment, unless there exist any significant underlying risks. Consecutively, this project will also bring in returns in the form of liquidity which when adjusted for a 15 percent hurdle rate, will still promise a high net present value. This should guarantee investor confidence in the venture.
However, there are instances where a hurdle rate is insignificant, for example, in circumstances where laws mandate the completion of the project. In such cases, it becomes unnecessary to pitch risks against potential gains.
References for Hurdle Rate
Academic Research on Hurdle Rate
Corporate investment decision practices and the hurdle rate premium puzzle, Meier, I., & Tarhan, V. (2007). This study surveys a cross-section of 127 companies to gain insight on various dimensions of firms’ investment decisions. This survey aims to address the hurdle rates firms use, calculations of project-related cash-flows, and the interaction of cash-flows and hurdle rates. The paper shows that survey firms do not always appear to handle the cash-flow dimension of their investment decisions in a consistent manner.
Evaluating investment projects: The hurdle rate, Chen, H. Y., & Ward, C. (2000). Journal of Corporate Real Estate, 2(4), 295-303. This paper discusses how to estimate the appropriate rate that should be used to investment projects, as well as the why projects might attract hurdle rates that are higher than the cost of capital. The paper discusses the gap between the hurdle rate and the cost of capital and explores possible explanations for the rational use of additional barriers before accepting capital projects.
Valuation and incentive effects of hurdle rate executive stock options, Cheung, J., & Corrado, C. (2009). Review of quantitative finance and accounting, 32(3), 269-285. This paper examines the criticisms of traditional executive stock options for inherently weak links between pay and performance. The paper shows how using the hurdle rate can solve this problem of criticism, but also highlights the different problems that companies might face when using this model. To solve this problem, the authors apply the Monte Carlo valuation approach developed by Longstaff and Schwartz to estimate the value of path-dependent American options. Findings and conclusions are documented in the paper.
Business valuation: modelling forecasting hurdle rate, Nangia, V. K., Agrawal, R., & Reddy, K. S. (2011). This paper explores the query of whether target firm shareholders are excessively paid, adequately rewarded, or stumply compensated. To address this query, the study aims to remix valuation parameters for better combination of mixture so that it represents fair deal value in merger and acquisition (M&A) negotiation process. The purpose of the study is to redesign the existing valuation methods, craft new models and compare them to suggest perceptive guidelines for “valuation governance”.
Hurdle rate: Executive stock options, Cheung, J., Corrado, C., Chay, J. B., & Jung, D. S. (2006). Australian Journal of Management, 31(1), 29-40. This paper explores the concept of executive stock options as an executive compensation plan in New Zealand and Australia. It examines the impact of a strike price combined with dividend protection feature on a hurdle rate set with reference to a cost of capital estimate.
Determination and use of a hurdle rate in the capital budgeting process: evidence from listed Australian companies, Kalyebara, B., & Ahmed, A. D. (2011). IUP Journal of Applied Finance, 17(2), 59. This paper reports the results of a questionnaire survey about the investment appraisal practices of the top 500 companies listed on the Australian Stock Exchange (ASX) and the internal and external factors which impact on the managers’ decisions. The paper shows that more than 41 respondents make use of Discounted cash flow techniques. It also shows that most companies use more than one technique for investment appraisal decisions. The paper highlights the most used techniques used to complement the DCF techniques.
Determining hurdle rate and capital allocation in credit portfolio management, Miu, P., Ozdemir, B., Cubukgil, E., & Giesinger, M. (2016). Journal of financial services research, 50(2), 243-273. This paper examines two interrelated issues in risk-adjusted return on capital performance measurement: estimating hurdle rates and allocating capital to debt instruments in a portfolio. The paper considers a methodology to differentiate hurdle rates for individual debt instruments that incorporates obligor-specific information. Using the proposed approach, the paper shows that the hurdle rate could be materially different among industry sectors and obligors of different credit quality.
Is a uniform hurdle rate relevant in a banking firm?, Carlin, T. M., Finch, N., Ford, G., & Petty, R. (2006). In this paper, the authors question the relevance, and assess the implications, of the practice in banking to use a uniform hurdle rate based on the cost of equity for the purposes of pricing and performance measurement. The paper examines the inconsistencies that may arise when risk-adjusted performance measures are benchmarked and set against a hurdle rate. It also analyses the ability for a bank to maintain a uniform hurdle rate, and develops a loan pricing framework to examine the impact of a uniform hurdle rate and whether or not it is of benefit to the bank.
Calculating a Project’s Hurdle Rate, Pike, R. (1980). Managerial Finance, 6(2), 76-88. This paper explores the importance of the determination of reliable hurdle rates, or minimum required rates of returns of investments to the long term profitability and level of investment in a company or economy. The paper presents the implications of hurdle rates which are set too high, and it also examines the differences in variances of hurdle rates. The paper concentrates on the application of one of the more recent approaches based on the capital asset pricing model (CAPM).
WACCs and Hurdle Rate, Schwarzbichler, M., Steiner, C., & Turnheim, D. (2018). In Financial Steering (pp. 21-37). Springer, Cham. This paper investigates the concept of the weighted average cost of capital (WACC), as well as its uses. The paper further explores the uses and benefits of this concept especially as a calculating tool.