What is Hurdle Rate?
When a firm decides to finance a project, the minimum rate it expects to earn through this investment is called hurdle rate. Hurdle rate is often also referred to as required rate of return and target rate. It enables the investor to assess which projects are feasible and profitable and should be pursued. Hurdle means obstacle, when a business is more likely to fail it faces many hurdles and becomes risky. So when a project is riskier the hurdle rate is higher for that project. In the hedge fund terms, it means rate of return that the fund manager must recover prior to gathering incentive fees.
A common formula used to measure this hurdle rate is as follows: Riskless State + Risk Premium = Hurdle Rate
In order evaluate risk one must go through a process because risk is an intangible measure. So putting a value on risk can be tough, especially converting it into a risk premium. A healthy risk and return model should look like this.
- Risk measure analysis can be conducted on all assets instead of a single item and the risk assessment must be consistent.
- There must be a lucid indication of the kinds of risk, those that can be remunerated as opposed to those who can’t.
- Measure of risk must be adaptable to a feasible rate of return for the investor or else the investor will lose his initial motivation.
- The model can only be sound if it is able to demonstrate past returns as well as future returns in a conducive fashion.
For example, a firm is deciding to invest in a shoe factory in a remote African state where shoes are not commonly worn and income is spent primarily on necessities rather than luxuries. The shoes have still not been considered a necessity. The investors will use risk analysis to decide whether this venture is feasible and what the returns on the investment would be. The risk is immense thus their returns would be greater too, if the company makes a profit. It is the company’s prerogative which formula it will use to determine the hurdle rate. For example it might have a pre-determined rate of 11% for non-risky businesses and 16% for high-risk businesses.