Define Hurdle Rate with Example, How is it Calculated?

The hurdle rate is an important concept in investment decision-making. It helps a company decide whether a proposed project or investment will generate a satisfactory return.

Definition of Hurdle Rate

A hurdle rate is the minimum required rate of return that an investment or project must earn to be considered acceptable. It represents the opportunity cost of capital and acts as a benchmark for evaluating investment proposals.

If the expected return of a project is higher than the hurdle rate, the project is usually accepted. If the expected return is lower, the project is generally rejected.

Calculation Method (Using WACC):

WACC = (E/V × Re) + (D/V × Rd × (1 – Tc))

Where,

E = Market value of equity, D = Market value of debt, V = Total value

Re = Cost of equity (using CAPM: Rf + β × (Rm – Rf))

Rd = Cost of debt, Tc = Tax rate

Practical Example:

A Company has 60% equity financing at 12% cost and 40% debt at 7% cost with 25% tax rate.

WACC = (0.60 × 12%) + (0.40 × 7% × (1 – 0.25))

= 7.2% + (0.40 × 7% × 0.75)

= 7.2% + 2.1%

= 9.3%

The hurdle rate for the company is 9.3%. Any project returning more than 9.3% should be accepted; projects returning less should be rejected.

In summary, the hurdle rate is the minimum acceptable return for an investment. It is commonly calculated using WACC and helps companies select projects that are likely to add value.

Investment Banking, Module: A, 98th BPE 6(a)