Why The Cost Of Capital Is Referred To As The Hurdle Rate In Capital Budgeting?

Cost of Capital and Hurdle Rate

Explain Why The Cost Of Capital Is Referred To As The Hurdle Rate In Capital Budgeting? 

Cost of the capital is the actual rate of the business through debt-equity capital. Cost of capital is one of the most critical factors when choosing a project. Cost of capital determines the present value of future cash flows of the project. It is the minimum rate of return, which allows the firm to break even (Eades, 2017). Cost of capital is called a hurdle rate as it aids the firm to benchmark the performance of the investment. Cost of capital also aids the firm to compare the rate of return of any project. It also aids the investors to set a benchmark to their new project. The benchmark aids the firm to decide whether they should accept or reject their new project or not (O'Brien, 2017). Every firm tries to generate more capital using the rate of return; otherwise, capital erosion will occur in the firm impacting the profitability of the firm negatively.

Every firm assumes their risk when entering new projects to their industry; therefore, they use WACC as hurdle rate, which aids in deciding whether they should enter the new project or not (Zhang, 2017). A hurdle rate is the lowest satisfactory rate of return (MIRR), which the investor expect from their investment. The hurdle rate below the cost of capital is not acceptable. This increases with the risk of the project. The higher the hurdle rate, the more risk the project will have. Most of the organisations use 12% hurdle rate. Hurdle rates are essential for determining the future value of the project. To determine hurdle rates, the cost of capital, returns should always be taken into consideration (Schwarzbichler, Steiner, & Turnheim, 2018). The hurdle rate is determined by assessing the cost of capital of the company. Before accepting any project, the investors evaluate whether the hurdle rate is greater than the internal rate of return or not. Investors expect a greater cost of capital of any project they would like to invest. Low hurdle rate evaluates the unprofitability of the project. The hurdle rate is set to the weighted average cost of capital of a company aiding the organisation to benchmark their performance. Hurdle rate aids the management to accept the best available project for their organisation, based on the financial factors. Cost of capital is referred to as the absolute minimum hurdle rate of the company. The hurdle rate is usually larger than the cost of capital of the company, indicating that the company has more investment opportunities. Every organisation uses its weighted average cost of capital as a hurdle rate to elect whether they should purchase a new project of not. Diversified firms use a number of hurdle rates in their capital budgeting process that helps them to measure the investments. The hurdle rate of an organisation is based on the cost of capital.

References

Zhang, G. (2017). Fundamental (versus Market) Risk and Capital Budgeting Decisions: Distinguishing between the Investment Hurdle Rate and the Cost of Capital. Available at SSRN 3019270.

Schwarzbichler, M., Steiner, C., & Turnheim, D. (2018). WACCs and Hurdle Rate. In Financial Steering (pp. 21-37). Springer, Cham.

Eades, K. M. (2017). Mead Corporation: Cost of Capital. Darden Business Publishing Cases.

O'Brien, T. (2017). Applied International Finance II: International Cost of Capital and Capital Budgeting. Business Expert Press.