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Home > Mergers and Acquisitions Best Practice > How to Set the Hurdle Rate for Capital Investments

Mergers and Acquisitions Best Practice

How to Set the Hurdle Rate for Capital Investments

by Jon Tucker

Executive Summary

  • There exists a wide range of approaches to setting the hurdle rate for capital investments.

  • It is essential that we do not set the hurdle rate too high, thereby foregoing valuable investment opportunities, or too low, thereby destroying value for shareholders.

  • While academics tend to advocate a series of, at times, complex adjustments, most CFOs settle for a relatively simple approach, and allow for complexity instead in their cash flow projections.

  • The most common approach is to employ a CAPM-based equity cost as an input to a WACC calculation.

  • A company-wide hurdle rate is typically employed by companies, although adjustments are made for projects of atypical risk.

Introduction

Chief financial officers are charged with the task of maximizing shareholder wealth. They do this by pursuing two key goals: Maximizing the stream of future cash flows, and minimizing the company’s cost of capital. Cognizant of the separation theorem, we tend to separate one goal from the other. However, both are of strategic importance—a healthy stream of cash flows can actually destroy value (and hence reduce shareholder wealth) if the company suffers from a high cost of capital. In a very real sense, then, a company’s cost of capital represents an important “hurdle,” which its portfolio of projects must exceed in order to create wealth for shareholders. Clearly, the cost of capital, as implied by the company’s financing mix, is a good starting point when arriving at the hurdle rate for capital investment appraisal (capital budgeting), but the way in which the company arrives at this cost of capital, and the adjustments made thereafter to arrive at the hurdle rate, warrant further explanation.

Hurdle Rate: A Definition

The hurdle rate is the required rate of return on investment appraisal, above which an investment project is worth pursuing. We know when computing a project’s net present value (NPV) that if the discount rate exceeds the project’s internal rate of return (IRR), then we should not proceed with the project. The starting point for the hurdle rate is, then, the company’s cost of capital, to which a company may then decide to make some adjustment for that project’s specific risk, perhaps adding a risk premium. The difficulty for practitioners is that there exists a wide variation of approaches to arriving at the hurdle rate—even academics cannot agree on the best way forward.

Some examples of the difficulties involved are: How do we arrive at the cost of equity capital? How do we arrive at the cost of debt and other financing components? Do we employ the weighted average cost of capital (WACC), or some other metric, to arrive at the cost of capital? If we do employ the WACC, how do we weight the cost of each financing component? What additional adjustment do we make for risk? We will tackle each of these issues in turn, and explore the broad alternative approaches available to the CFO.

The Cost of Equity

There are a variety of ways in which CFOs tend to compute the cost of equity capital. The most prominent and widely employed approach is the capital asset pricing model (CAPM):1

re = rf + β (rmrf)

where:

re = the expected cost of equity capital for a company;

rf = the risk-free rate of return;

β = the share beta;

rm = the return on the market portfolio;

rmrf = the expected premium offered by the market portfolio over and above the risk-free rate.

However, we encounter a number of difficulties with this approach in a practical setting. Which risk-free rate should be employed—a three-month Treasury bill rate, or a long-term government bond rate? Most academics would suggest the latter, although in practice, the three-month rate is often employed. Should CFOs compute their own beta coefficient, or employ a beta computed by data agencies such as Bloomberg? This is a matter of personal choice, although in practice most companies probably employ an externally published source. What equity risk premium should be employed, and is it realistic in terms of expectations? We could apply an average historical risk premium here, or even estimate the rate implied by current asset prices. Further, if we compute our own average historical premium figure, then applying the geometric average premium is probably the best approach. Each of these issues could warrant a chapter to itself—in the real world, CFOs arrive at a CAPM-based equity cost of capital after much debate within the company, and consultation with their external corporate advisers (such as investment banks). Academics have extended the CAPM to a multi-factor framework to better capture equity risk, adding size and book-to-market factors, although in practice it is unlikely that companies employ such models extensively.

An alternative approach is to employ an earnings model to arrive at the cost of equity capital, that is, to compute the price-to-earnings (PE) ratio (or earnings yield) for a company. This is a relatively simple procedure, given the wide availability of PE ratios, and the broad understanding and use of asset yields in the financial media, although it is most appropriately employed for non-growth companies. The cost of equity, then, is equal to the inverse of the PE ratio:

re = E ÷ P

where:

re = the company’s cost of equity capital;

E = the company’s earnings;

P = the company’s share price.

A further alternative is to arrive at the cost of equity capital by means of a simple dividend model. When we rearrange the dividend model, the cost of equity capital equals the expected dividend yield (D1/P0) plus the constant compound growth rate of dividends, the latter often based on past trends as a proxy for growth expectations:

re = D1 ÷ P0 + g

where:

re = the company’s cost of equity capital;

D1 = the dividend in year 1;

P = the company’s share price in year 0;

g = the growth rate of dividends.

In the real world, CFOs should probably compute a cost of equity using all three approaches, benchmark their rate with other companies in their industry (which are likely to have similar betas, business models, and enjoy similar access to financial markets), and only then settle on a suitable figure. In the case of pure equity-financed companies, the cost of equity capital is, by definition, the pivotal figure in arriving at the hurdle rate.

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Further reading

Book:

  • Bierman, Harold, Jr., and Seymour Smidt. The Capital Budgeting Decision: Economic Analysis of Investment Projects. 9th ed. New York: Routledge, 2006.

Articles:

  • Bruner, Robert F., Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins. “Best practices in estimating the cost of capital: Survey and synthesis.” Financial Practice and Education 8:1 (Spring/Summer 1998): 13–28.
  • McLaney, Edward, John Pointon, Melanie Thomas, and Jon Tucker. “Practitioners’ perspectives on the cost of capital.” European Journal of Finance 10:2 (April 2004): 123–138. Online at: dx.doi.org/10.1080/1351847032000137401

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