In capital budgeting, projects are often evaluated by comparing the internal rate of return (IRR) on a project to the hurdle rate, or minimum acceptable rate of return (MARR). Under this approach, if the IRR is equal to or greater than the hurdle rate, the project is likely to be approved. If it is not, the project is typically rejected.
The hurdle rate is the minimum rate that the company or manager expects to earn when investing in a project. The IRR, on the other hand, is the interest rate at which the net present value (NPV) of all cash flows, both positive and negative, from a project is equal to zero.
Projects are also evaluated by discounting future cash flows to the present by the hurdle rate in order to calculate the NPV, which represents the difference between the present value of cash inflows and the present value of cash outflows.
Generally, the hurdle rate is equal to the company's costs of capital, which is a combination of the cost of equity and the cost of debt. Managers typically raise the hurdle rate for riskier projects or when the company is comparing multiple investment opportunities.
While it is relatively straightforward to evaluate projects by comparing the IRR to the MARR, this approach has certain limitations as an investing strategy. For example, it looks only at the rate of return, as opposed to the size of the return. A $2 investment returning $20 would have a much higher rate of return than a $2 million investment returning $4 million to a company.
IRR can only be used when looking at projects and investments that have an initial cash outflow followed by one or more inflows. Also, this method does not consider the possibility that various projects might have different durations.