when businesses assess future projects they often begin with the wacc which conveys the average rate a company is expected to pay to finance its assets accounting for its equity and debt 1 the wacc is calculated by weighing the cost of each capital component equity preferred stock and debt according to its proportion in the overall capital structure in practical terms wacc is a benchmark that presents the minimum return a company must generate on its projects to satisfy its shareholders and debt holders when a company evaluates new projects using wacc plus the risk premium ensures that these initiatives are expected to yield returns at least equal to the company s current cost of capital plus the risk premium this aligns management decisions with the expectations of investors 
companies can use the net present value npv approach as part of their assessment npv involves calculating the difference between the present value of cash inflows and outflows over the project s life span future cash flows are estimated and then discounted to their present value using a discount rate typically the hurdle rate which is often the wacc the npv is the sum of these discounted cash flows minus the costs for the initial investment cost if the npv is positive the projected earnings discounted to present value are higher than the expected costs suggesting the project is likely profitable there is also a method that uses the internal rate of return irr the discount rate that makes the npv of all cash flows from a project equal to zero 2 essentially it represents the break even rate of return expected from the project thus a project is generally considered viable if its irr is greater than the hurdle rate which is often set as the wacc the irr method is handy for comparing the profitability of different investment opportunities providing a rate of return perspective that complements the absolute value approach of npv formula and calculating hurdle ratessince the hurdle rate is the lowest return a company expects from an investment to justify the risk we can use the wacc to help calculate this rate the wacc reflects the average rate of return a company must earn on its investments to satisfy its shareholders and debt holders let s say you manage a company evaluating investing in sophisticated manufacturing equipment your engineers estimate the new equipment could result in a 20 increase in production efficiency that is an roi of 20 here is the standard formula for the hurdle rate for companies weighing an investment a simplified wacc calculation makes this quicker and easier you just need the following to calculate it suppose this is the financial data for your firm to arrive at the table below we determine the proportional weight of the firm s capital components common stock preferred stock and debt first we calculate the weighted cost of each then we multiply each component s cost or return rate by its proportional weight in the total capital structure finally we total up these weighted percentages we now need the other element in the equation for the hurdle rate namely the risk premium in finance a risk premium is the extra return above the risk free rate that investors demand for taking on extra risk virtually all investments carry more risk than u s treasurys so we can use the yield on the 10 year u s treasury as the benchmark for the risk free rate incorporating the 10 year treasury yield as a risk premium into the hurdle rate helps ensure that it makes up for the market risk represented by the wacc and the opportunity cost of investing in the new manufacturing equipment in this example we assume the 10 year treasury yields 4 5 since the estimated return on investment of 20 is greater than the hurdle rate of 13 26 purchasing the new machine would be prudent the investment is expected to yield returns that exceed the minimum rate required to justify the risk and cost of capital if however it were only expected to yield 10 it should probably be passed over like other investment decision making tools the hurdle rate is only an estimate there is no guarantee that returns will match the results of the calculation in private equity the hurdle rate has a slightly different meaning referring to the minimum rate of return a fund has to achieve before the general partners gps or managers start receiving a share of the profits known as carried interest it acts as a performance threshold that ensures limited partners lps get a certain return on their investment before the general partners receive theirs hurdle rates in private equity typically range from 7 to 8 but can vary based on the fund s strategy and the agreement between lps and gps only after reaching the hurdle rate do gps start receiving their share of the profits often about 20 of the fund s returns above the hurdle rate suppose a private equity fund has the following details if the fund s return is below 8 all returns are distributed to the lps and the gps do not receive carried interest any returns above the 8 hurdle rate are shared between the lps and the gps who receive about 20 in this example this arrangement aligns the interests of the fund managers with those of the investors giving an incentive to the gps to exceed the hurdle rate to achieve their share of the profits there are variations in hurdle rate structures some private equity funds employ a fixed hurdle rate while others might link it to a benchmark making it variable there can be tiered hurdle rates in more complex arrangements with different levels of carried interest rates applying up a ladder of performance thresholds limitations of the hurdle ratehurdle rates typically favor projects or investments with high rates of return on a percentage basis even if the dollar value is smaller suppose project a has a return of 20 and a dollar profit value of 10 and project b has a return of 10 and a dollar profit value of 20 project a would be more likely chosen because it has a higher rate of return even though it returns less in terms of overall dollar value in addition choosing a risk premium is difficult since it s not guaranteed a project or investment may return more or less than expected if the rate is chosen incorrectly it can result in a flawed use of funds or missed opportunities hurdle rate vs internal rate of return irr the hurdle rate and irr are both key financial metrics used in investment and capital budgeting but they serve different purposes and are used in different ways the hurdle rate is essentially the minimum acceptable return on an investment it is often set at the company s wacc added to the risk free rate although it can be adjusted higher for riskier projects it is used as a benchmark to determine whether an investment is worth pursuing if the expected return on a project is higher than the hurdle rate the project is typically considered viable the hurdle rate is therefore formulated before the assessment of an investment the irr however is the rate at which the net present value npv of all the cash flows both positive and negative from a project or investment equals zero it is used to estimate the profitability of potential investments a higher irr indicates a more profitable investment unlike the hurdle rate the irr is calculated based on the expected cash flows from the project 