Hurdle Rates
Most organizations that account for risks when selecting projects do so using hurdle rates. The hurdle rate is a risk-adjusted cost of capital used to discount future project costs and benefits. Increased hurdle rates are applied to projects considered to be risky.
Using hurdle rates is preferable to ignoring risk or treating it as an intangible. However, hurdle rates have limitations. For one thing, organizations are frequently unclear about what hurdle rate should be applied. Studies have shown that the rates used by firms vary considerably. According to finance theory, the "correct" hurdle rate is the "opportunity cost" of the investment, which is the return available from investing in securities equivalent to the risk of the project being evaluated. Most companies don't adjust the hurdle rate for risk nearly enough.
A more fundamental problem is reflected in research on real options showing that the discount rate needs to vary with time and with project management strategy. For example, an irreversible project investment would call for a higher hurdle rate. Note that the discount rate is not a constant, but changes depending on when the future discounted outcomes are expected to occur. Using a constant hurdle rate for a project implicitly assumes that uncertainty increases over time in a specific way (i.e. geometrically). Hence hurdle rates tend to create a bias toward short-term, quick-payoff projects because they severely penalize project benefits that occur in the longer term.
|
The Need for Project Selection Risk Management
