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?: 1--the initial investment (i.e., total cost of the project), 2--the financing cost for the project (i.e., the firm's cost of capital), and 3--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.

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is relatively simple to calculate, as it is composed of the rate of interest paid.

In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default)

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 fourth 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.

(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 companys 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.

GLOSSARY Average cost of capital: The average percentage cost that a company pays for the money that it is currently using (i.e., money raised in the past). Not very useful, except to public utilities. Marginal cost of capital: The average percentage cost that a company will have to pay to raise money now (i.e., money to be raised in the future). Cost of debt: The rate of return that must be earned on the investment of borrowed money in order to keep the common stock price unchanged. Cost of preferred stock: The rate of return that must be earned on the investment of money raised from the sale of preferred stock in order to keep the common stock price unchanged. Cost of retained earnings: The rate of return that must be earned on the investment of retained earnings in order to keep the common stock price unchanged. Cost of new common equity: The rate of return that must be earned on the investment of money raised from the sale of new common stock in order to keep the common stock price unchanged.

Companies raise money from a variety of sources: (1) short-term sources such as accounts payable, bank loans, and commercial paper, and (2) long-term sources such as bonds, preferred stock, retained earnings, and sale of stock. When companies invest this money (in the companies assets), they obviously want to earn at least the average cost of raising the funds. In other words, it would be foolish to raise money at an average cost of 7% and then invest that money in the company to earn less than 7%. In other words, the cost of raising the money, called the cost of capital, becomes the minimum desired rate of return for investing the money. If the cost of capital is 8.5%, then the minimum desired rate of return for investing the money is 8.5%. However, while it might be interesting to calculate the average cost of raising money from all these sources, it may not be very useful. This is because companies rarely finance their assets by raising money across the board from all these sources. However, companies do follow the matching principle, which says that short-term assets should be financed with short-term liabilities and long-term assets should be financed with long-term sources. While we might be able to survive a mistake in purchasing short-term assets, mistakes in purchasing long-term assets stay with us much longer and are more expensive. Therefore, we want to ensure that fixed assets earn at least the cost of financing them. If we want to avoid making a major mistake like this, it is particularly important that we calculate accurately the cost of capital raised from long-term sources. The most accurate term for this would be "the cost of long-term capital" but it is generally shortened to the term "cost of capital." How to Calculate the Cost of Capital The cost of capital is simply a weighted average of the cost of the individual sources (i.e., bonds, preferred stock, retained earnings, and sale of new common stock). For example, assume that you raise 40% of your money in the form of debt, 20% in preferred stock, and 40% in common equity. Given the cost of each shown in the table below, the weighted cost of capital for the company would be 7.0%. Proportion * Cost = Wt. Cost 0.40 * 5% = 2.0% 0.20 * 7% = 1.4% 0.40 * 9% = 3.6% Cost of Capital = 7.0% Lets look at a few details for calculating the cost of each component. Cost of Debt Debt is special in the sense that its interest payments are tax-deductible. While this is a good thing, it does present a problem when comparing its cost with the cost of the other components, whose costs are not taxdeductible. The solution? Simply place the cost of debt on an after-tax basis the same basis as the other

sources. We do this by simply multiplying the interest rate times [1 - the tax rate]. For example, if a company pays an interest rate of 8% and is in the 40% tax bracket, the after-tax cost of debt would be: Cost of debt = interest rate * (1 tax rate) Cost of debt = Cost of debt = 8% * (1 0.40) 4.8%

Cost of Preferred Stock The cost of money raised by selling preferred stock is, generically, the dollar cost divided by the amount of money raised. If a company sells $1 million worth of preferred stock, pays the investment banker $100,000 for its help with the sale, and pays $70,000 in annual preferred stock dividends, the cost of preferred stock is equal to:

Cost of Retained Earnings Stockholders let the companys management keep some of the earnings and reinvest them back into the company (rather than paying it to them in the form of dividends). This does not mean that these retained earnings are free however the stockholders still expect to earn a rate of return on the companys investment of this money. The rate of return that the company must earn on the investment of this money (in order to keep the shareholders happy) is called the cost of retained earnings. The formula for calculating the cost of retained earnings is shown below:

Cost of New Equity The cost of raising money through the sale of new common stock is the same as the cost of retained earnings, with one exception: flotation costs. Money earned in the companys operations (i.e., retained earnings) is readily available with paying any outside agency; money raised from outside the company often comes with

commissions and fees (i.e., flotation fees) attached. The formula for the cost of new common equity is as follows:

Weighted Marginal Cost of Capital Assume that Genuine Products, Inc. is raising money for expansion of its operation. It has part of the money already set aside in the form of cash from this year's addition to retained earnings. In order to stay at its optimal capital structure, it has decided to raise the money in the following proportions: 40% debt, 10% preferred stock, 20% retained earnings, and 30% from the sale of new common stock. Assuming that the company can raise money at the costs calculated above, the company's marginal cost of capital will be: Proportion * Cost = Wt. Cost

0.40 * 4.80% = 1.92% 0.10 * 7.78% = 0.78% 0.20 * 11.00% = 2.20% 0.30 * 11.50% = 3.45% Cost of capital = 8.35%