# Hurdle rate and cost of capital > What return a bet must beat, and why riskier bets need more. - Course: [Finance for Product People: From Unit Economics to Business Cases](https://productovi.com/courses/finance-for-product.md) - Module: Is this bet worth making? - Lesson 23/32, ~27 min - Source: https://productovi.com/courses/finance-for-product/hurdle-rate ## Where 25% comes from **Alex Tutor:** You're still on Klasna's product team, and Leo has a question about the 25% rate. **Leo:** Why do we discount at 25%? The bank lends us money at 16%. Use 16% and more of our ideas pass. **Hanna:** The loan is only a quarter of our money. The other three quarters came from the founders and investors, who took a much bigger risk. They expect about 28% a year. **Sofia:** So the rate is a mix of what the bank wants and what the owners want? **Alex Tutor:** Exactly. Weight each source by its share: 25% × 16% + 75% × 28% = 4% + 21% = 25%. That is Klasna's **cost of capital**, often called WACC, the weighted average cost of capital. $$ WACC = \frac{D}{D+E} \times r_D + \frac{E}{D+E} \times r_E = 0.25 \times 16\% + 0.75 \times 28\% = 25\% $$ *D: debt (loans), E: equity (owners' money); r_D, r_E: what lenders and owners expect a year. Interest usually lowers tax, which trims the debt part; we leave taxes out here.* **Alex Tutor:** A bet that earns less than 25% doesn't pay the people whose money it uses. Try a different mix. > **Exercise:** Suppose Klasna were financed **40%** by loans at 16% and **60%** by owners expecting 28%, with the same rates. What would its weighted cost of capital be? ## Cheap debt isn't free **Leo:** So we borrow more and everything gets cheaper! **Alex Tutor:** The bank is paid first, in a good month or a bad July. The more debt, the riskier the owners' share becomes, so they ask for more than 28%. Part of the paper gain disappears. **Hanna:** And the bank wants its repayment in August too, when our cash is at its lowest. **Sofia:** So the 23.2% assumes the owners don't notice the extra risk. **Alex Tutor:** Right. How much debt is healthy is a question for later. For now, the cost of capital is what all of the money costs, not the cheapest piece of it. > **Exercise:** **True or false:** if Klasna takes on much more debt, the return its owners expect is likely to **rise**. ## One rate for every bet? **Leo:** Fine, 25% then. For everything. **Alex Tutor:** 25% is the return for Klasna's **average** risk. Bets aren't average. Cutting a known bill is safer than a new feature, and a new market is riskier still. **Hanna:** So our policy has three **hurdle rates**, the minimum return a bet must beat: 25% for efficiency projects with known costs, 30% for product bets on current customers, 40% for new markets. **Alex Tutor:** Before the table: sort a few bets by risk yourself. > **Exercise:** Klasna's cost of capital, 25%, is the hurdle for bets of average risk with known costs. Which of these bets should face a hurdle **above** 25%? Select all that apply. > **Klasna's hurdle rates** > > | Kind of bet | Example | Hurdle rate | > |---|---|---| > | Efficiency, known costs | Replacing a paid tool or vendor | 25% (the cost of capital) | > | Product bet, current customers | Maths mock-exam mode | 30% | > | New market | Klasna for Teams in Poland | 40% | > > The extra points over 25% pay for the extra risk of the bet, not for doubts about the forecast. **Alex Tutor:** The mock-exam mode had an NPV of +161,280 at 25%. It's a product bet, so check it at 30%: −1,200,000, then 300,000, 600,000, 800,000, 800,000. > **Exercise:** What is the **NPV** of the mock-exam mode at its 30% hurdle rate (−1,200,000 now; 300,000, 600,000, 800,000, 800,000 in years 1–4)? ## The new-market trap **Leo:** Then look at Teams in Poland: 2,000,000 in, then 500,000, 900,000, 1,200,000 and 1,200,000. At 25% the NPV is +81,920. Approved? **Alex Tutor:** At its own 40% hurdle the NPV is −433,985.84. Its IRR is 26.97%: above the company average, far below the risk of a new country, new sales and a new currency. **Hanna:** With one rate for everything, risky bets look better than they are, safe ones look worse, and year by year the company drifts into risk without anyone deciding to. **Sofia:** So the hurdle depends on the bet, not on who pays for it. > **Exercise:** Teams in Poland has an IRR of 26.97%. Klasna's cost of capital is 25%, and its hurdle for new markets is 40%. What should Klasna decide? ## Don't pad the rate **Leo:** Then let's use 40% for everything. Better safe than sorry. **Alex Tutor:** Then good, safer bets fail too: the mock exams drop to −179,800.08 at 40%. A rate that is too high is as wrong as one that is too low; it just loses money more quietly. **Hanna:** And never raise the rate because you don't trust a forecast. If the cash flows look rosy, fix them or test scenarios. **Sofia:** The rate is for risk, the forecast is for the cash we expect. **Hanna:** Here's the situation I meet every quarter. > **Exercise:** Hanna doubts the mock-exam team's forecast of 800,000 UAH a year in years 3 and 4: it looks rosy. The bet is a product bet with a 30% hurdle. What should she do? > **Exercise:** Match each rate to what it means at Klasna. ## Your turn: answer Leo **Leo:** One more try: the bank gives us 16%. Why can't Poland be judged at 16%? **Alex Tutor:** Show Leo what 16% would do to the numbers. > **Exercise:** Teams in Poland: −2,000,000 UAH now, then 500,000, 900,000, 1,200,000 and 1,200,000 at the end of years 1–4. What would its **NPV** be if it were judged at the bank's **16%** loan rate? Round to two decimals. **Sofia:** Because the loan pays for only a part of it, and Poland is the riskiest thing on the list. **Hanna:** Put the numbers next to that, and he'll stop asking. **Alex Tutor:** Three to five sentences: the cost of capital, the hurdle and why, and the NPV at each rate. > **Exercise:** Leo asks: "The bank lends at 16%. Why can't we judge Teams in Poland at 16%?" Teams in Poland costs 2,000,000 UAH now and brings 500,000, 900,000, 1,200,000 and 1,200,000 in years 1–4: NPV +531,419.62 at 16%, +81,920 at 25% and −433,985.84 at 40%. Write a short reply (3–5 sentences) using Klasna's cost of capital, the hurdle for new markets and the NPVs. > **Key ideas** > > - **Cost of capital (WACC)**: what all of the company's money costs, weighted by source: 25% × 16% (loans) + 75% × 28% (owners) = 25%. > - More debt lowers the paper number (40% debt → 23.2%), but the owners' risk and the return they expect rise with it. > - **Hurdle rate**: the minimum return a bet must beat, set by its risk: 25% for efficiency with known costs, 30% for product bets, 40% for new markets. > - One rate for everything flatters risky bets: Teams in Poland shows NPV +81,920 at 25% but −433,985.84 at its 40% hurdle (IRR 26.97%). > - A rate set too high kills good bets too (mock exams: +30,033.96 at 30%, −179,800.08 at 40%). > - The rate prices risk; doubts about the forecast are fixed in the cash flows or with scenarios. **Alex Tutor:** Next: the case. Build our own video classroom or keep paying per minute, with everything from this module. - Previous lesson: [NPV, IRR and payback for a product bet](https://productovi.com/courses/finance-for-product/npv-irr-payback.md) - Next lesson: [Case: build our own video classroom or keep paying per minute?](https://productovi.com/courses/finance-for-product/build-or-buy-case.md) --- Productovi Learning. Free, no sign-up needed to read.