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The risk involved in proposed investments directly affects the hurdle rate. The higher the risk, the higher the hurdle rate will be. This is because the hurdle rate is the minimum rate of return expected on an investment, which needs to compensate for the risk taken. Therefore, if an investment is deemed risky, the company will set a higher hurdle rate to ensure that the potential return justifies the risk.
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Determine the initial cash outlay – this includes items such as equipment costs, shipping costs, installation costs, start-up costs, training for the people involved, etc. "Everything that goes into getting the project up and running has to be part of your initial cash outlays. If you're just buying a new machine, it's pretty easy to estimate all the costs. A project or initiative that is likely to take several months will be harder," Knight says. Forecast the cash flows from the investment – here, you need to estimate the net cash the investment will bring, allowing for variables like increased working capital, changes in taxes and adjustments for non-cash expenses. Putting the cash flows on a calendar will aid your estimation of returns year by year or even month by month. Determine the minimum return – the minimum rate of return is often called a "hurdle rate." Companies may have more than one hurdle rate depending on the risk involved in proposed investments. Knight says: "The fina...
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Need help with which companies or projects to invest in? As a key driver of value in business, ROIC measures how well the company deploys its capital....
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