LO 48.5: Calculate the hurdle rate and apply this rate in making business decisions

LO 48.5: Calculate the hurdle rate and apply this rate in making business decisions using RAROC.
Similar to internal rate of return (IRR) analysis, the use of a hurdle rate (i.e., after-tax weighted average cost of equity capital) is compared to RAROC in making business decisions. In general, the hurdle rate should be revised perhaps once or twice a year or when it has moved by over 10%.
The hurdle rate, hAT is computed as follows:
hA T
(CE x R c e ) + (PE x R pe )
(CE + PE)
where: CE = market value of common equity PE = market value of preferred equity R^P = cost of common equity [could be derived from the capital asset pricing model (CAPM)] RpE = cost of preferred equity (yield on preferred shares)
Recall, that the CAPM formula is as follows:
R CE = r
f + P c e ( R m r
f )
where: Rp = risk-free rate r m = expected return on market portfolio PCE = firms common equity market beta
Once the hurdle rate and the RAROC are calculated, the following rules apply:
If RAROC > hurdle rate, there is value creation from the project and it should be accepted. If RAROC hurdle rate (accepted projects) also come with high risk that could ultimately result in losses and reduce the value of the firm. In addition, lower return projects that have a RAROC < hurdle rate (rejected projects) also come with low risk that could provide steady returns and increase the value of the firm. As a result, an adjusted RAROC measure should be computed.
2018 Kaplan, Inc.
Page 135
Topic 48 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 17
A d j u s t e d RAROC