A hurdle rate is the minimal rate of return demanded by management or investor on a project or investment. It enables businesses to make critical decisions about whether or not to pursue a certain project. The hurdle rate is a measure of the acceptable compensation for the amount of risk in a project; greater hurdle rates are associated with riskier ventures than lower hurdle rates. The following are some of the factors to consider when determining the rate: related risks, cost of capital, and the returns of other potential investments or projects.
Hurdle rates are very important in the business world, especially when it comes to future endeavours and projects. Companies determine whether they will take on capital projects based on the level of risk associated with it. If an expected rate of return is above the hurdle rate, the investment is considered sound. If the rate of return falls below the hurdle rate, the investor may choose not to move forward. A hurdle rate is also referred to as a break-even yield.
The hurdle rate is also used to discount a project’s future cash flows to its net present value.
Example of Hurdle Rate
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.