WACC vs hurdle rate

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.

⏱️TIMESTAMPS⏱️
0:00 Introduction to WACC and hurdle rate
0:21 Synonyms for hurdle rate
1:10 Definition of WACC
2:15 Meaning of hurdle rate
3:49 Hurdle rate vs risk level
4:42 Hurdle rate and estimated returns

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.    • WACC explained  

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! 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!

Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!