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How do you handle multiple hurdle rates for a portfolio of projects?

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Hurdle rates are the minimum required returns for accepting a project or investment. They reflect the risk and opportunity cost of capital for different types of projects. But how do you handle multiple hurdle rates for a portfolio of projects? In this article, you will learn why and how to use different hurdle rates for different projects, and some best practices for applying them.

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Simon Pritchard GAICD

Dad. Board and C-suite strategic advisor. Better Big Business Bets.

1 Why use multiple hurdle rates?

Using a single hurdle rate for all projects may lead to over- or under-investment in some areas of your business. For example, if you use a high hurdle rate based on your overall cost of capital, you may reject some profitable projects that have lower risk and higher cash flows. On the other hand, if you use a low hurdle rate based on your average return on investment, you may accept some unprofitable projects that have higher risk and lower cash flows. Therefore, using multiple hurdle rates that reflect the risk and return characteristics of different projects can help you allocate your capital more efficiently and effectively.

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2 How to determine multiple hurdle rates?

One way to determine multiple hurdle rates is to use the weighted average cost of capital (WACC) as a baseline, and then adjust it according to the risk and return profiles of different projects. For example, you can use a higher hurdle rate for projects that have higher risk, lower cash flow stability, longer payback periods, or lower strategic value. Conversely, you can use a lower hurdle rate for projects that have lower risk, higher cash flow stability, shorter payback periods, or higher strategic value. Another way to determine multiple hurdle rates is to use the capital asset pricing model (CAPM), which estimates the required return for a project based on its systematic risk, or beta. For example, you can use a higher hurdle rate for projects that have higher beta, meaning they are more sensitive to market fluctuations, and a lower hurdle rate for projects that have lower beta, meaning they are less sensitive to market fluctuations.

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Simon Pritchard GAICD

Dad. Board and C-suite strategic advisor. Better Big Business Bets.
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The article suggests two different approaches. I disagree with the first approach. When a company is considering an investment opportunity, it should first answer whether the opportunity has a similar or distinctly different beta risk to its existing portfolio. If it is similar, it’s reasonable to assume that the opportunity cost of capital (OCC) equals the average cost of capital for the company. It’s then safe to use the latter as the hurdle rate. If it is different, then the OCC can be estimated using the CAPM, with beta estimated using a basket of publicly traded assets similar to the investment opportunity. Payback period and strategic value are irrelevant.

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3 How to apply multiple hurdle rates?

Once you have determined the appropriate hurdle rates for different projects, you can apply them to evaluate and rank your project portfolio. You can use various capital budgeting techniques, such as net present value (NPV), internal rate of return (IRR), or profitability index (PI), to compare the expected returns of each project with its corresponding hurdle rate. You can then accept the projects that have positive NPV, higher IRR, or higher PI than their hurdle rates, and reject the projects that have negative NPV, lower IRR, or lower PI than their hurdle rates. You can also use the modified internal rate of return (MIRR), which incorporates the reinvestment rate of the project cash flows, to compare the projects with different hurdle rates more accurately.

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Simon Pritchard GAICD

Dad. Board and C-suite strategic advisor. Better Big Business Bets.
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This article confuses hurdle rates, cost of capital, investment metrics, and capital prioritisation. Let’s assume that by hurdle rates, we mean the opportunity cost of capital (OCC) for each investment. If we calculate our investment metrics with the OCC, we can identify all investments with a positive NPV. The same investments will have an IRR > Hurdle Rate. In the absence of capital constraints, basic capital budgeting suggests choosing all of these. If we are capital constrained, basic capital budgeting suggests ranking by capital efficiency ratio (NPV/capital), which will maximise value for a constrained amount of capital. This will yield a subset of the NPV positive investments.

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4 What are some best practices for using multiple hurdle rates?

Applying multiple hurdle rates to capital budgeting decisions can help you make better choices, but it requires careful analysis and communication. To use multiple hurdle rates effectively, you should have consistent and transparent criteria for assigning different rates to projects. You should also review and update your hurdle rates regularly to reflect changes in market conditions, risk preferences, and strategic objectives. Additionally, it’s important to explain your rationale for using multiple hurdle rates to stakeholders such as managers, investors, and lenders. By following these best practices, you can optimize your capital allocation and maximize value creation with multiple hurdle rates.

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Simon Pritchard GAICD

Dad. Board and C-suite strategic advisor. Better Big Business Bets.
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The practical issue in an organisation is how to manage motivational and confirmation biases. When project risk and therefore cost of capital is lower than average, advocates are quick to highlight that. When it’s higher than average, less so (unless they’re selling the project). One way to manage this is to create a protocol in advance for the types of investments that are higher or lower than average, and/or a methodology to determine them. This avoids project by project debate.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you handle multiple hurdle rates for a portfolio of projects?

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1 Why use multiple hurdle rates?

2 How to determine multiple hurdle rates?

3 How to apply multiple hurdle rates?

4 What are some best practices for using multiple hurdle rates?

5 Here’s what else to consider

Capital Budgeting

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