Although determining hurdle rate for an investment is not a straight forward thing as it depends on many subjective assumptions, in theory it should not be too hard to determine as it is composed of the following factors: cost of capital, risks involved, rates of return for similar investments, current business expansion opportunities, and other factors that could directly affect an investment. The general rule is that hurdle rate should not be less than internal rate of return for an investment.
However, question is how come hurdle rates have not come down since the beginning of the global financial crisis following the decrease in cost of capital? I think this is one of the fundamental questions of modern era valuation. It seems profitability thresholds for companies have increased in the meantime as the difference between hurdle rates and cost of capital are historically high. This implies management’s risk perception to be very high and I am not certain these risks are well reflected in today’s valuations.
