Risk is a central element of the business world. Risky but successful projects can give investors an incredible return on their investment. But risky and unsuccessful projects have the potential to leave you with nothing. Estimating the risk associated with an investment is therefore an essential part of business practice.
In this post we cover the first aspect of the Investment Decision for corporate finance: hurdle rate. The hurdle rate reflects the riskiness of an investment and the mix of debt and equity to fund it. Simply put, the hurdle rate sets the minimum expectation of return for a specific investment.
As mentioned in Fundamentals of Corporate Finance, the Risk Premium captures the difference between a safe investment and a risky investment. Thus, we can describe the hurdle rate as follows: Hurdle Rate = Riskless Rate + Risk Premium.
The description outlines three major questions.
- What is risk and riskless?
- How do we measure risk?
- How to quantify risk into a risk premium?
Risk and Riskless
Mathematically, the variance in actual returns around expected returns is the measurement of the risk of an investment. Simply put, it describes the relationship between an expectation and an actual return. The larger the difference between the actual and expected returns, the riskier the investment.
A riskless investment is an investment with a certain and known rate of return, and with no chance of default. Strictly speaking there are no riskless investments. In practical terms US treasury securities are considered riskless because the US government is considered the best possible issuer of securities in the market.
Even though riskless strictly speaking does not exist, the level of risk is so small it can be ignored. The downside of a riskless investment is that the rate of return is very low and that the returns are exposed to inflation risk.
Rewarded and Unrewarded Risk
There are two types of risk: rewarded and unrewarded risk.
Unrewarded risk, or market risk, is a risk that affects all investments across the market. It is unrewarded because taking the risk does not yield any advantage over the rest of the market. For example: risks associated with compliance to safety standards are unrewarded risks because all market players must comply.
Rewarded risk, or firm specific risk, is a risk that is specific to the investment. It is rewarded because it may give you a competitive advantage in the market.
A smart investor should diversify their investment portfolio so that the total firm-specific risk is averaged out across the portfolio. It’s reasonable to assume that any investor holds a “diversified” portfolio, thus investors price only market risk.
When we talk about market risk, it’s important to understand what we mean by ‘market’. The market pertains to not only the country where we sell our goods or services, but also the specific industry we compete in.
Considering the above, we can anticipate some challenges when trying to estimate the market risk.
A lot of businesses and corporations are operating worldwide. That means the risk of the firm depends on which markets they are exposed to and by how much. A firm which collects 90% of their revenue in the US market will be less risky than a firm that performs the same business in South Africa. The exact market risk for a firm depends on the specific mix of markets it operates in.
As a rule of thumb we could argue it’s more sensible to determine the risk based on where the firm is operating as opposed to where it is incorporated.
Furthermore, large corporations are active in different fields. A corporation such as McDonalds is in the business of not only selling food, but also real-estate. The industry risk associated with each business is different. The exact market risk for a firm will depend on the specific mix of industries it is active in
Measuring and Quantifying Risk
There are several methods to measure market risk.
- CAPM or Capital Asset Pricing Model
- APM: Asset Pricing Model
- Multi-Factor Models
- Proxy Models
While the CAPM is limited in many ways, it has survived as the default model for risk in equity valuation. The alternative models do a better job explaining past returns but are less effective in predicting future returns. Furthermore, they are much more complex and require a lot more information than CAPM. Lastly, the difference in expected returns predicted by the alternative models and CAPM is not significant enough to justify the additional work.
As it is an extensive topic, we will cover the CAPM in a different post.
The CAPM will give us the cost of equity related to an investment. However, a firm can also raise funds for an investment project from debt.
Simply put, debt is a deferred repayment of a sum of money. It is a commitment to make fixed payments with as main advantage that it is tax deductible. However, failure to make payments can lead to default or loss of control of the firm.
Debt includes short-term and long-term interest-bearing liabilities (i.e. loans or corporate bonds) or any lease obligations.
When we talk about the Cost of Debt, we talk about the cost associated with raising funds from debt.
We will cover debt in more detail in a different post.
Cost of Capital
The weighted average cost of equity and cost of debt is called the cost of capital. To determine the weight for equity and debt, the preferred method is to use market value. It is relatively easy to determine the market value for equity, but can be more difficult for private companies.
Determining the market value of debt is challenging for both public and private companies. Hence most practitioners opt for the book value of debt as a proxy for market value.
Choosing the Hurdle Rate
Finally, the choice of hurdle rate still depends on the preference of the managers. As said, the hurdle rate is the internal benchmark for projects. Using the cost of capital as hurdle rate is a common, solid choice but not mandatory.
If your firm is a start-up which is looking for angel investors to provide equity it is reasonable to use cost of equity as a hurdle rate.