Hurdle Rate Calculation

I am trying to learn how to calculate the hurdle rate and saw the following example below:

My Question: Why is the Hurdle rate = risk free rate + project beta * (return on the broad market - risk free rate) ?

Example

You are financial analyst at Jovan Arsen, Inc., a bus operator which is interested in bidding for a public transport tender of a city government in a South Asian country. The project requires Jovan to purchase and operate buses on designated routes.

Following data is available:

The company has to invest in 50 buses each costing $50,000 and operate it for 5 years. Total initial investment outlay is expected to be $3 million. The project has no salvage value. The city government has guaranteed to ply each bus for at least 50,000 kilometers at $1.75 per kilometer. The company’s variable costs are $1 per kilometer and its fixed costs are $250,000 per annum. Risk free rate is 5% and the company’s risk analyst has worked out the project beta to be 1.8. Return on the broad market is 10%. Weighted average cost of capital of the company is 8%. The country has offered full tax exemption.

Solution

We need to work out the net after tax cash flows for each of the five years of the project, which are calculated as follows:

Net annual cash flows = annual cash inflows – annual cash outflows

Annual cash inflows = rate/km ($1.75) * number of kilometers (50,000) * number of buses (50) = $4.375 million

Annual cash outflows = variable cost ($1) * number of kilometers (50,000) * number of buses (50) + fixed costs ($250,000) = $2.75 million

Net annual cash flows = $4.375 million - $2.75 million = $1.625 million

Net initial investment = $3 million

In order to do the net present value analysis, we need to discount the future cash flows. The hurdle rate to be used for discounting must be based on the risk inherent in the project. Capital asset pricing model can be used to calculate the risk-adjusted discount rate to be used.

Hurdle rate = 5% + 1.8 * (10% - 5%) = 14%

The present value factor for 5 years annuity is 3.4331.

Present value of future net cash flows = 3.4331 * $1.625 million = $5.56 million

Net present value = present value of cash flows – initial investment = $5.56 million - $3 million = $2.56 million

Since the project has positive NPV at the given hurdle rate of 14%, the project should be accepted.