The Hurdle Rate |
Very Important Background Material: The following point is so crucial to understanding the capital budgeting process that it is repeated in several places on these pages.
Capital budgeting analysis centers around a very simple question:
If I make this investment, will I recover the following three items?:
the initial investment (i.e., total cost of the project),
the financing cost for the project (i.e., the firm's cost of capital), and
enough money to compensate me for the risk that my cash flow estimates may be incorrect (i.e., the risk premium)
The Hurdle Rate
The hurdle rate is the minimum acceptable rate of return on a capital investment project. The term is usually associated with one particular method of analysis - the net present value method of capital budgeting.
As we will see on this page, the hurdle rate is equal to the company's cost of capital plus the project's risk premium, i.e.,
Hurdle Rate = Cost of Capital + Risk Premium
For example, on a particular investment project, the minimum acceptable rate might be:
Hurdle Rate = 10.00% + 1.50%
Hurdle Rate = 11.50%
What If We Borrow Money To Finance The Project?
Why doesn't a company want to invest money in a project for less than its cost of capital? This can be restated in simpler terms: Would you want to borrow money from the bank at 5% annual interest and then invest that money to earn 2%? Obviously not ... this would be foolish. In the same way, a company doesn't want to raise money and then invest the money for less than that rate. So the cost of capital is the absolute minimum rate that is acceptable when investing that money.
As an example, consider this. Assume for the moment that money does not have a time value; in other words, money is free - you do not have to pay interest if you borrow it and do not have to pay dividends to your shareholders. If this is true, what is the minimum rate of return you would have to expect to earn when you invest that money?
The minimum would be zero percent - in other words, you would invest the money if you could get your money back and earn a $1 profit. If a project cost $100,000 and guaranteed to give you back $100,001 over the next few years, then you would invest in the project. Let's call the $100,000 cost the initial investment. If money is free and the timing of cash flows doesn't matter, i.e., the cost of capital is 0%, then you only have to get back the initial investment plus $1 for the project to be profitable.
Let's now change the assumption that money is free. Instead, let's assume that raising the $100,000 costs you an average of 10% per year, i.e., money has a cost of capital of 10%. For the moment, let's call the 10% your financing cost.
Now, in order for you to invest this money in a project, you have to believe that the project will earn at least 10% per year. In other words, before you invest, you now have to expect to get back the initial investment plus the financing cost.
If money costs 10% per year, would you invest $100,000 in a project that repaid you $25,000 a year for four years plus the interest on the borrowed money? (If you use the $25,000 per year to pay off the loan, the total interest would be $25,000, broken down as follows:
$10,000 the first year (i.e., $100,000 loan * 10%)
$ 7,500 the second year (i.e., $75,000 loan * 10%)
$ 5,000 the third year (i.e., $50,000 loan * 10%)
$ 2,500 the first year (i.e., $25,000 loan * 10%)
$25,000 = Total interest paid over the four years
This is another way of saying that the total cost of financing the project is $25,000.
So, would you invest $100,000 in a project that pays you the following guaranteed cash returns?
Yes, because the project gives you back $1 above the sum of your initial investment of $100,000 and annual interest expenses that total $25,000. Again, our general principle is that, to be acceptable, the project must earn enough money to pay back the initial investment plus the financing cost. Or, put another way, the project's minimum acceptable rate of return is the company's cost of capital.
(For those who are familiar with time value of money concepts, the present value of the cash inflows above is $100,000.68, which is greater than the initial investment of $100,000 by $0.68. Again, the answer is "Yes, I would make the investment.")
Why Is It Better To Use The Cost of Capital Than Just The Cost of Debt?
But wait a minute! In the previous section, we only considered the use of debt to finance the project. It appears to be reasonable to use the cost of debt (10% in the example above) as the minimum required rate of return for the project. Or does it?
If the company borrows a sizable amount of money to finance the project, the debt-to-equity ratio of the company will increase. And as the debt-to-equity ratio increases, the risk to the stockholders increases. After all, if the company should default on its debt and/or the company goes into bankruptcy, the debt will have to paid in full before the common shareholders receive anything. In other words, as the debt level increases, the risk of the shareholders increases as well.
Obviously, the shareholders expect to be compensated for this increase in risk. We are going to have to pay the shareholders a higher rate of return if we finance the project entirely with debt. But how does this affect what we did in the previous section, which was to use the cost of debt as the minimum rate of return for our project?
If we use just the cost of debt as the project's minimum rate of return, then we are overlooking the effect that the higher debt level has on the stockholders. To incorporate both the debt's cost and the stockholders' higher requirements, we need to take a weighted average of the two. In other words, we need to use the overall weighted cost of capital.
For example, assume that after borrowing the needed funds, the company has raised 40% of its money in the form of debt and 60% in equity. We will use these percentages as the weighting factors. Assuming that the after-tax cost of debt is 8% and the cost of equity (after the additional borrowing) is 15%, then the weighted cost of capital is 0.40 * 8% + 0.60 * 15%, or 3.2% + 9.0%, or 12.2%. Using this as the required rate of return for the project ensures that we are including all of the financing costs for the project.
Click on this link for a more complete discussion of the cost of capital.
Why Use the Risk Premium?
But is the cost of capital really the minimum rate of return on a project? If you are certain that you will receive the promised cash inflows, then yes, the cost of capital is the minimum rate of return for the project. However, future cash flows that are 100% certain are somewhat rare; there is almost always some uncertainty (or risk) in the cash flow estimates. If the cash inflows shown above are estimated earnings, some of the estimates are probably better than others. In particular, the further the cash flows are in the future, the more likely that the estimates will be erroneous.
What can we do to protect ourselves from accepting an investment project that, in retrospect, will end up losing us money because our estimates turn out to be erroneous? There are several ways to manage this risk, but one common way is simply to add a risk premium to the company's cost of capital and to use this rate as the project's minimum required rate of return. (A risk premium is an extra return that is earned for accepting added risk.)
The higher the risk of our cash inflow estimates, the higher the risk premium. If we have a great deal of confidence that our estimates will prove to be accurate, the risk premium may be very small (probably less than 1.00%). If we don't have faith in the accuracy of our estimates, we may use a risk premium of several percentage points.
By adding a risk premium to the cost of capital, we are requiring a higher rate of return on the project. If we invest in the project because it meets this higher hurdle, some of the actual cash flows can be less than our estimates and we will still make money on the project. In other words, by adding the risk premium, we will eliminate some marginally profitable projects from consideration and improve our odds of investing only in truly profitable projects.
In fact, the analysis of most capital budgeting proposals are structured in such a way that it tilts the result in this direction - to avoid investing in an unprofitable investment. The company is willing to accept a reasonable risk that it will reject some marginally profitable investments, if it can lower the risk of accepting a project that will end up losing money. Consider that the company faces four possibilities for the outcome:
1. The project is profitable, and the company invests in it. (A good decision.)
2. The project is profitable, and the company rejects it. Borrowing a term from statistics, this is known as a Type 1 error – realizing an opportunity loss by failing to invest in a profitable investment.
3. The project will lose money, and the company chooses to invest in it. This is known as a Type 2 error – realizing a real loss that leads to a decrease in the company’s cash position.
4. The project will lose money, and the company rejects it. (A good decision.)
The company is quite willing to accept a reasonable level for Type 1 errors if it can reduce the change of making a Type 2 error. After all, opportunity losses don't hurt nearly as much as realized losses. By increasing the risk premium to higher and higher levels, the expected profitability (i.e., present value of the benefits) decreases, and the chance of accepting a project that will actually lose money will decrease.
The Hurdle Rate
By using the hurdle rate (i.e., cost of capital + risk premium) as the project's minimum acceptable rate of return, we increase the likelihood that any projects that we accept will indeed be profitable, even if some of our estimates turn out to be inaccurate. In other words, if we set the hurdle high enough and the project is profitable enough to clear it, then we can be wrong on some of our estimates and still be O.K.