Determining Flexible Hurdle Rates

When properly used, flexible hurdle rates can provide reasonable yardsticks for judging prospective spending proposals, and they also avoid the pitfalls associated with using a single hurdle rate. To apply flexible hurdle rates to your capital spending program, you will need to rate each proposal according to its degree of risk. High-risk proposals should require a relatively high rate of return to be acceptable; medium-risk, a somewhat lower return; and low-risk proposals, an even lower rate. Minimum-return standards for each risk category are based on assumed-risk capital costs. This approach involves three basic, relatively easy steps:

● Find appropriate debt/equity ratios for each of the categories of risk. If you were to finance a high-risk project in the open market, you would probably have to do so largely by raising equity capital. These days, few banks are willing to take the chance of lending for risky enterprises. A medium-risk venture could probably be financed with a combination of new equity and a bank loan. In a low-risk venture, your banker would lend you most, if not all, of the needed funds.

While the precise debt/equity ratio used for each risk category will depend on your industry, the size of your company and your own financial underpinnings, there is a general pattern. The debt/equity ratio for most companies will fall within the following ranges:
High-risk: debt = 0%–20% equity = 80%–100%
Medium-risk: debt = 30%–40% equity = 60%–70%
Low-risk: debt = 80%–100% equity = 0%–20%

● Calculate after-tax debt and equity costs. Next, establish a reasonable after-tax cost basis for raising new debt and equity capital. We can refer back to the example used in our discussion of capital costs (see page 58). We will assume average debt costs of 7.9 percent and equity costs of 12.5 percent.

● Calculate hurdle rates by computing a weighted cost of capital for each category. First, determine what percentages of the total financing for a given project will be accounted for by debt and equity, based on the guidelines that were mentioned above. Then multiply each percentage by the appropriate cost of capital to get the weighted cost of capital. The sum of the weighted costs is your minimum return, a desirable rate for each risk classification.
Illustration: Using earlier examples, here is how to calculate typical hurdle rates:

Debt 7.9% x .10 = 0.79
High-risk (10% debt, 90% equity) Equity 12.5% x .90 = 11.25
Capital cost = 12.04%

Debt 7.9% x .35 = 2.77
Medium-risk (35% debt, 65% equity) Equity 12.5% x .65 = 8.12
Capital cost = 10.89%

Debt 7.9% x .90 = 7.11
Low-risk (90% debt, 10% equity) Equity 12.5% x .10 = 1.25
Capital cost = 8.36%


➤ Observation: The crucial element in using flexible hurdle rates is your assessment of the risk involved in each project. How do you determine the difference between a medium-risk project and a high-risk one? This leads directly to the area of risk analysis, which we will discuss below.

Analyzing Your Capital Investment Risks
No capital investment project is ever without risk because there is no completely reliable way to forecast future cash flow. Nevertheless, there are various degrees of risk involved in different types of capital projects. For instance, the marketing of a new product, or entry into a new market, carries a higher risk than other types of projects. This is because management has no experience to draw on in this situation, which leads to imprecise cash-flow forecasts.

Thus, you can equate the risk in any given capital investment project with the probability of a variance in your projected cash flows. For instance, the replacement of a worn-out machine with a new one is usually a low-risk project. You have precise knowledge of (1) what the new machine can do, (2) how much more efficient it is than the old machine, and (3) the cost savings or productivity boosts that will result from replacement. Thus, the odds of a major deviation from cash-flow projections are small.