Question

What hurdle rate issue arises when evaluating leveraged buyouts.

What is the appropriate hurdle rate that the analyst should use?

When the acquirer and the target company operate in different industries, what hurdle rate issue arises?

Answer 1

A hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors that could directly affect an investment.

Following issues can be arises when evaluating leaveraged buyouts.:-

• Hurdle rates can favor investments with high rates of return, even if Net Present Value is very small.
• They may reject huge dollar value projects that may generate more cash for the investors but at a lower rate of return.
• The cost of capital is usually the basis of a hurdle rate and it may change over time.

2. The absolute minimum hurdle rate should be the company's cost of capital (a blend of the cost of debt and the cost of equity). However, the hurdle rate is usually larger than the cost of capital when the company has many investment opportunities and for projects that have a higher level of risk.

3.Since when acquirer and target company operates in different industries, the main issue is that cost of capital of both industry will be changed depanding on that particular industry circumstances,nature of competitiveness,consumer preferences etc.