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How do you incorporate non-financial factors into the hurdle rate decision?

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The hurdle rate is the minimum return that a project or investment must generate to be accepted by a company. It reflects the opportunity cost of capital, the risk of the project, and the financial goals of the company. But what about the non-financial factors that may also influence the decision to invest or not? How do you incorporate them into the hurdle rate calculation? In this article, you will learn how to identify and evaluate the non-financial factors that may affect your hurdle rate decision, and how to adjust your hurdle rate accordingly.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of…

1 Non-financial factors examples

Non-financial factors are the qualitative or intangible aspects of a project or investment that may not be captured by the financial analysis. They may include environmental, social, ethical, strategic, or competitive considerations that may have a positive or negative impact on the company's performance, reputation, or stakeholders. For example, a project may have a high environmental or social benefit, but a low financial return, or vice versa. A project may also enhance the company's competitive advantage, innovation, or market share, but entail higher risk or uncertainty. Non-financial factors may vary depending on the industry, the company, and the project.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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Some non-financial factors of a project or investment are to be considered of the following: 1. Improving staff morale, making it easier to recruit and retain employees 2. Improving relationships with suppliers and customers 3. Adhering to the legislations set by the relevant regulatory authority 4. Protecting the intellectual property of the company 5. Maintaining the good reputation of the company, industry standards and good practices Above are some examples of non-financial factors apart from the quantitative factors such as using Net Present Value (NPV) or Return on Investment (ROI) to assess the profitability of the project.

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2 Non-financial factors evaluation

Non-financial factors are often difficult to measure and quantify, but they should not be ignored or overlooked in the hurdle rate decision. They may have a significant influence on the company's long-term value, sustainability, and growth. Therefore, you need to evaluate the non-financial factors that are relevant and important for your project or investment, and assess their potential impact on your cash flows, risk, and opportunity cost. You can use various methods and tools to evaluate non-financial factors, such as SWOT analysis, stakeholder analysis, scenario analysis, or balanced scorecard.

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3 Hurdle rate adjustment

Once you have evaluated the non-financial factors, you need to adjust your hurdle rate accordingly. You can do this by adding or subtracting a premium or discount to your base hurdle rate, which is usually determined by the weighted average cost of capital (WACC). The premium or discount should reflect the degree and direction of the impact of the non-financial factors on your project or investment. For example, if a project has a high environmental or social benefit, you may lower your hurdle rate to reflect the positive externalities. If a project has a high strategic or competitive value, you may raise your hurdle rate to reflect the higher opportunity cost. The adjustment should be based on your judgment and analysis, and be consistent with your company's objectives and criteria.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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When comes to the adjustment of the hurdle rate, we have to take into consideration the certainty of the cash flows and also the country where the project is to be carried out. For instance, if a country has a very unstable political circumstances due to striking etc, hence the hurdle rate will be higher. A higher discounted rate will result in a lower present value of all future cash flows. Also, it means that it is important to have cash earlier than later due to the highly uncertainty of future cash flow projections.

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4 Hurdle rate challenges

Adjusting your hurdle rate for non-financial factors may pose some challenges and limitations. First, you may face some subjectivity and bias in identifying and evaluating the non-financial factors, and in determining the appropriate premium or discount. You may need to consult with different stakeholders, experts, or sources to validate your assumptions and estimates. Second, you may encounter some trade-offs and conflicts between the financial and non-financial factors, and between the short-term and long-term effects. You may need to balance and prioritize the different factors and perspectives, and align them with your company's vision and mission. Third, you may have to deal with some uncertainty and volatility in the non-financial factors, and their impact on your project or investment. You may need to monitor and update your hurdle rate regularly, and be flexible and adaptable to changing conditions and expectations.

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5 Hurdle rate best practices

To incorporate non-financial factors into your hurdle rate decision effectively and efficiently, you should follow some best practices. First, you should define and communicate your company's goals and values clearly and consistently, and use them as a guide for your hurdle rate decision. Second, you should identify and evaluate the non-financial factors systematically and comprehensively, and use reliable and relevant data and methods. Third, you should adjust your hurdle rate reasonably and transparently, and explain the rationale and implications of your adjustment. Fourth, you should review and revise your hurdle rate periodically and proactively, and respond to feedback and changes.

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Meng Hock Tan ????

External Audit | Financial Reporting | Know Your Client Compliance | Big Four | Associate Member of the Institute of Singapore Chartered Accountants (ISCA)
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When evaluating and choosing the investment, hurdle rates serve as a fundamental benchmark, distinguishing between what is merely good and what is truly great. It is calculating using the WACC. In this case, the risk premium has to be adjusted based on the non-financial factors for calculating the estimated cost of equity.

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6 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 incorporate non-financial factors into the hurdle rate decision?

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1 Non-financial factors examples

2 Non-financial factors evaluation

3 Hurdle rate adjustment

4 Hurdle rate challenges

5 Hurdle rate best practices

6 Here’s what else to consider

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