Project IRR & Hurdle Calculations

KClubs's picture
Rank: Senior Orangutan | 391

There is a project. We have some cashflows. We know how long it takes. We can find an IRR for this project. This project has some performance incentives involved. If the IRR > X, one group gets a bonus payment. The bonus payment is going to be 10% of profit above X (the hurdle rate).

Option 1: Discount the project cashflows by the hurdle rate to find what the cashflows would be if the IRR was exactly the hurdle rate. Then subtract the "Hurdle Cashflows" from the actual "Project Cashflows". (The difference between these is equivalent to the percentage difference in IRR over the hurdle rate, but expressed in dollar figures). Sum the differences (for every period) to get your excess profit above the hurdle rate, multiply by 10%, and there's your bonus payment.

Option 2: Manipulate the last set of cashflows (the sale of the project in the last month/year) in order to make the project IRR equal the hurdle rate. The amount that you decrease the last set of cashflows to match the hurdle IRR is your excess profit. Multiply by 10%, and there's your bonus payment.

Which option are you going with and explain why. More detail the better.

Comments (2)

Most Helpful
Jul 8, 2019

Create "shares" that are really options that are only in the money above some hurdle rate. For example in year 1 the strike would be (1+hurdle rate) and year two and so on. Distribute the cash on a per share basis where the options are paid first then the remaining cash distributed by ownership and you'll get the IRR for you. This just makes it more dynamic and is closer to your Option 1.

In that case you're actually only paying your % ownership of the incentive payment. Or to put it another way, they are paying themselves as part of the bonus payment and you are not on the hook for all of it. You will keep more cash this way.

Jul 8, 2019