WACC and hurdle rate are closely related concepts used in evaluating investment project proposals.
In business meetings they are often used as synonyms, even though the definitions of WACC
and hurdle rate are slightly different.
This video explains what WACC and hurdle rate are, and how to best use them.
In business, we often use many different names for almost the same thing.
WACC. Discount rate. Cost of Capital.
Rate of Return. Target rate.
Opportunity cost of capital.
Cutoff rate. Hurdle rate.
Minimum Acceptable Rate of Return.
Required Rate of Return.
Depending on the company you work for, any one of these can be the name for a minimum
return that the business wants a project manager to commit to,
before an investment budget is granted.
Let’s keep things simple, and focus on the two most common ones out of this long list:
WACC and hurdle rate.
It’s best to start with WACC, as the hurdle rate is merely a variation on WACC.
The WACC is the Weighted Average Cost of Capital.
WACC is a calculation of a firm's cost of capital in which each category of capital
is proportionately weighted.
Investors buy shares in a company and banks supply a loan to a company to make a return.
They want to get a bigger bag of money out of the investment than what they put in.
The required rate of return for all types of capital combined is the WACC.
The money that the company has now raised gets invested in the company’s operations.
Same idea here: the company aims to get a bigger bag of money out of the investment
than what was put in.
That’s why a project manager and his finance person will calculate the IRR for the investment
project, based on assumptions of how much to invest,
and the size and timing of the expected benefits.
If the rate of return on the investment project on the right (the IRR) is bigger than the
cost of capital on the left (the WACC), then the CFO is likely to approve the investment
as it creates value.
However, some CFOs are a little tougher than that, raising the bar on the required returns.
They use a variation on WACC called the hurdle rate.
I think that’s an excellent term, hurdle rate: the project manager is asked to “jump
the hurdle” to get investment money, and in that race he’s competing with other projects
(and other project managers) that want to win the same prize!
Here are two examples of approaches that a CFO might take.
The hurdle rate tends to be set at the WACC plus a couple of percentage points.
Let’s say that the WACC for the company in this example is 10%.
On the left, the CFO in blue sets the hurdle rate at 12%, WACC plus 2 percentage points,
to create value for the company.
He only accepts project proposals if they promise an IRR of 12% or more.
11% would not be good enough, it might be higher than the WACC, but it’s lower than
the hurdle rate.
The CFO in red, on the right, takes a different approach.
He sets the hurdle rate at 16%, at WACC of 10% plus 6 percentage points.
This hurdle rate is far higher than the WACC.
The reason for this is that the CFO is red only wants to consider the very best projects
with IRRs that significantly exceed the WACC.
He raised the bar significantly!
Some CFOs set hurdle rate levels in a somewhat arbitrary way,
others use a more structured approach.
The hurdle rate describes the appropriate expected returns for the level of risk that
is estimated.
Riskier projects generally have higher hurdle rates than those with less risk.
Here are some items considered risky: depending on one customer for sales of the finished
product, operating a complex supply chain where lots of things could go wrong, being
single-sourced with just one supplier for key components, a gap in team experience and
knowledge, or intense competition in the market.
For project A, the first, fourth, and fifth item apply.
Some of these can be remedied, for example the company could put a stronger team together
to lead the project, which will reduce the risk.
That’s a trade-off between resources and risk.
Setting a relatively low or relatively high hurdle rate is a balancing act between the
number of projects to consider and the estimated returns.
The higher the hurdle rate, the lower the number of projects submitted.
As business life is dynamic (conditions and projections change all the time), it might
be a good idea to keep a running list of project candidates.
What that means is to have three possible responses to investment proposals: yes (approved),
no (rejected), and not yet (the parking lot).
Why would you keep projects in the “not yet” category?
First of all, it’s good to have some backup projects, in case approved projects A, B and
F don’t work out as planned.
Second, the project economics of the “not yet” projects might change: projected benefits
could increase, or the upfront investment might decrease.
Third, more investment money might become available that is looking for projects to
spend itself on.
The hurdle rate: a useful tool to allocate investment money
to the projects competing for it!
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