WACC vs Hurdle Rate
I wanted to know the advantages and disadvantages in using a hurdle rate instead of a WACC when valuing a company.
Any thoughts?
Hurdle Rate vs Wacc
The hurdle rate is a benchmark for the rate if return that is set by an investor or manager. On the other hand the weighted average cost of capital (WACC) is the cost of the capital. This includes all sources of capital.
@Bullet-Tooth Tony"
A hurdle rate may be higher or lower than a company's WACC. That means, a company could set a target return that is lower than it's WACC and take on projects that actually detract from the value of the firm. Conversely, it could set a higher hurdle that forces it to reject projects above WACC that still add value.
Again, this is rather academic. In practice, many companies may use a hurdle rate. IMO, it would be most effective to tie a hurdle rate to your WACC (i.e. WACC + 2%) knowing there are finite resources and time available for investment decisions.
@StoicTrader"
In a classroom, corporate finance setting, hurdle rate and WACC are the same thing. WACC is used as a hurdle rate to assess whether or not a company produces value for investors measured by ROIC. If a company's WACC is greater than it's ROIC then the company is generating a net negative return on capital and vice versa.
"WACC can be used as a hurdle rate against which to assess ROIC performance. Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the company's return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere."
http://www.investopedia.com/articles/fundamental/0...
The hurdle rate definition mentioned above is another definition for it. Hedge Funds use hurdle rates as well. This is the HF basically saying before we take x % of profits we must generate x % return for you.
WACC Explained
What is Hurdle Rate?
https://www.youtube.com/watch?v=q6FcylOMTm8
A hurdle rate may be higher or lower than a company's WACC. That means, a company could set a target return that is lower than it's WACC and take on projects that actually detract from the value of the firm. Conversely, it could set a higher hurdle that forces it to reject projects above WACC that still add value.
Again, this is rather academic. In practice, many companies may use a hurdle rate. IMO, it would be most effective to tie a hurdle rate to your WACC (i.e. WACC + 2%) knowing there are finite resources and time available for investment decisions.
Thanks a lot. Your opinion on tying hurdle rate to WACC is definitely something to think about.
As far as I've heard it used, hurdle rate is the minimum acceptable return for a specific project/investment. WACC reflects the overall operating and financial risk of the firm. A firm is essentially a portfolio of many different projects, each possibly having a different level of risk. So at least in theory, a firm's "hurdle rate" in capital budgeting could be very different among projects and it wouldn't make sense to use any one of these hurdle rates in calculating firm value. The unlevered cost of capital would be some weighted average of these hurdle rates and WACC would then consider the effects of financial leverage. I doubt anybody ever thinks of cost of capital in this "bottom-up" way in practice, because it's not in any way practical. But in theory that's the idea.
The takeaway from that view, though, is to think about the different projects of the firm when you're using CAPM / calculating cost of capital. If the firm is investing in very different projects now than 2 years ago, estimating beta using the past three years of returns makes no sense. In that case you'd be better off looking at comparable companies, if they exist, that better reflect the new direction of the company.
Thanks for the comment. You raise a great point about the similarity of previous project risk to current risk. Excellent point.
Hurdle rate Vs WACC (Originally Posted: 11/14/2014)
I need to know how hurdle rate is calculated and what is the different between hurdle rate and WACC
Hurdle rate is just the cost of an LP's capital for a PE firm. It's a set figure (not calculated), and then you benchmark actual performance against it to see if the PE firm's management gets any incentive fees.
CHItizen is correct -- the hurdle rate is some negotiated figure in an LP doc that says the equity firm must deliver, for example, 6% annually before it starts earning carry.
Additionally, some PE folks will occasionally refer to the minimum equity IRR required to approve a deal internally as a hurdle rate. Depending on the market and the PE firm, in other words, an investment committee might simply require an 18% - 25% equity IRR in order to do a deal. This too tends to be an arbitrary-ish number either not rooted or only loosely rooted in math.
WACC is discussed in length elsewhere on WSO and more broadly on the internet.
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