6 Questions on the Path to Financially Justified Projects: Developing Cash Flow Models – Part 3
What is the hurdle rate your company uses?
No company has an unlimited source of funds from which to execute its strategy. It stands to reason that with limited funds available, those projects funneled through the selection criteria must be profitable if the organization is to achieve its intended strategy. This limitation imposes upon the organization the need to make thoughtful, calculated decisions concerning what projects receive funding approval. A key component of this decision process is a company’s selection of their expected/required rate of return, or the “hurdle rate” that must be achieved to make projects a worthwhile investment in their particular business setting.
To make it worthwhile, project investment returns always need to be higher than the cost of capital. The WACC (percentage) represents the cost of capital and is used most often as the hurdle rate, but not always. If used as the hurdle rate to make and evaluate investment decisions, the WACC would represent the minimum required rate-of-return at which a company produces value for its investors. The WACC is appropriately used as the hurdle rate if you are confident the promised future cash flows will be received.
Many finance professionals assume that the historical WACC is automatically the correct discount rate with which to assess a prospective project’s NPV. This assumption is the company’s WACC should not extend to all projects. What matters most is the relative risk profile of the specific project under consideration, and its ability to generate net free cash flow that is certain.
While risky projects may provide leapfrog advantages to an organization, overall risk increases and financial certainty fades, as future cash flow estimates are likely to be flawed (e.g. high probability of cost overruns). When project risk is higher than the company’s existing complement of average or typical undertakings as reflected in its historical WACC, a project risk premium should be added to the company’s cost of capital. This provides a hurdle rate equal to the company’s cost of capital plus the project’s risk premium.
This protective measure employed by the company compensates for accepting the added risk by requiring a risk-adjusted rate of return. The profitability expressed by the NPV calculation is lowered and the chance of accepting the project is also lowered. Evaluating alternatives by requiring a higher rate tilts results in favor of selecting profitable projects, while eliminating from consideration marginally profitable projects. The inevitable tradeoff here is between realizing an “opportunity loss” versus realizing a “real loss.” In the latter situation, there is a real economic loss and the company is shedding value.
Risk premiums can vary from less than one percent to several percentage points; and inversely, especially-low-risk projects may warrant a downward adjustment in the WACC to account for the risk differential. Establishing the hurdle rate(s) has more to do with careful reflection and forward-looking vision than a finance department formula. Influencing factors, assumptions, or judgments might include the economic horizon, competitive forces, industry conditions, type of financing anticipated, risk tolerance (obviously a major factor), faith in the accuracy of the estimates, and the company’s overall situation (e.g., cash position/liquidly).
Always consult your finance department or CFO on these important questions and any appropriate method(s) or guidelines specified within your organization. Armed with this knowledge, you are likely to build cash flow models your superiors will take seriously. Furthermore, it will demonstrate your understanding and initiative, meaning you will likely earn considerable credibility with that department (or other key decision makers) which, incidentally, may ultimately have final word or control the purse strings on your current or future project.