A critical rate of profitability is the minimum rate of profitability of a project or investment required by a manager or investor. Profitability rates are very important in the business world, especially when it comes to future projects. A risk premium is often assigned to a potential investment to denote the expected risk. Let's break down the hurdle rate and learn how to use it.
What is the critical rate of profitability
A critical rate of profitability is the minimum rate of profitability of a project or investment required by a manager or investor. It allows companies to make important decisions about whether or not to move forward with a specific project. The hurdle rate describes the appropriate compensation for the level of risk present: riskier projects typically have higher rates than less risky ones. To determine the rate, you must take into account the associated risks, the cost of capital and the profitability of other possible investments or projects.
What is the critical rate of profitability for?
Profitability rates are very important in the business world, especially when it comes to future projects. Companies determine whether to take on a capital project based on the level of risk associated with it. If the expected rate of return is greater than the hurdle rate, the investment is considered sound. If the rate of return falls below the hurdle rate, the investor may decide not to proceed further. The hurdle rate is also called the equilibrium yield. There are two ways to evaluate the viability of a project:
- In the first, a company decides based on the net present value (NPV) approach by performing a discounted cash flow (DCF) analysis.
- In the second method, the internal rate of profitability (IRR) of the project is calculated and compared with the hurdle rate. If the IRR exceeds the hurdle rate, the project will most likely continue.
How the hurdle rate is used
A risk premium is often assigned to a potential investment to denote the expected risk. The higher the risk, the higher the risk premium should be, as it takes into account the fact that if the risk of losing your money is higher, the return on your investment should also be higher. The risk premium is usually added to the WACC to obtain a more appropriate hurdle rate. Using a hurdle rate to determine the potential of an investment helps eliminate any bias created by project preference. By assigning an appropriate risk factor, an investor can use the hurdle rate to demonstrate whether the project has financial merit independent of any assigned intrinsic value.
Critical rate of profitability formula. Source: WallStreetMojo.
Example of using the hurdle rate
Let's give an example to better understand how the hurdle rate works. Let's say there is a company that manufactures microchips that is going to buy a new machine. He estimates that with this new machine he can increase his sales of microchips, which will bring him a 15% return on his investment. The company's WACC is 6% and the risk of not selling more microchips is low, so it is assigned a low risk premium of 4%. The critical rate of profitability is then
WACC (6%) + Risk premium (4%) = 10%. Since the critical rate of profitability is 10% and the expected return on the investment is higher, 15%, the purchase of the new machinery would be a good investment.