Loading the player...

What is a 'Hurdle Rate'

A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. The hurdle rate denotes appropriate compensation for the level of risk present; riskier projects generally have higher hurdle rates than those that are deemed to be less risky.

In hedge funds, the hurdle rate refers to the rate of return that the fund manager must beat before collecting incentive fees.

BREAKING DOWN 'Hurdle Rate'

A hurdle rate functions as a parameter for comparison when determining the worthiness of a particular investment compared to the associated risk. If an anticipated rate of return is above the hurdle rate, the investment is considered to be sound. If the rate of return falls below the hurdle rate, the investor may choose not to move forward. A hurdle rate may also be referred to as a break-even yield.

In capital budgeting, projects are evaluated either by discounting future cash flows to the present by the hurdle rate, so as to ascertain the net present value of the project, or by computing the internal rate of return (IRR) on the project and comparing this to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely proceed.

Example of How to Use a Hurdle Rate

During the analysis of a potential investment, a risk premium is assigned to denote the anticipated amount of risk involved with the project in question. Risk premiums may be positive or negative, with negative rates helping to offset other factors that may make an investment look less appealing if the involved risk was not so low.

Using a hurdle rate to determine an investment's potential helps eliminate any bias created by personal preference towards a project. By assigning an appropriate risk factor, the hurdle rate can be used to demonstrate whether the project has financial merit regardless of any intrinsic value that may be assigned.

For example, a company with a hurdle rate of 10% for acceptable projects would most likely accept a project if it has an internal rate of return of 14% and does not have a significantly higher degree of risk. Alternately, discounting the future cash flows of this project by the hurdle rate of 10% would lead to a large and positive net present value, which would also lead to the project's acceptance.

In situations where a legal requirement exists in regards to the completion of the project, the hurdle rate is deemed a non-factor. Regardless of the risks or anticipated returns, mandated projects move forward to assure compliance with any applicable laws or regulations.

RELATED TERMS
  1. Performance Fee

    A performance fee is a payment made to an investment manager ...
  2. Profitability Index Rule

    The profitability index rule is a regulation for evaluating whether ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting ...
  4. The Net Internal Rate of Return ...

    Net internal rate of return (net IRR) is a performance measure ...
  5. Capital Risk

    Capital risk is the potential of loss of part or all of an investment.
  6. Capital Investment Analysis

    Capital investment analysis is a budgeting procedure that companies ...
Related Articles
  1. Financial Advisor

    A Guide on the Risk-Adjusted Discount Rate

    When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the risk-adjusted discount rate.
  2. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  3. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  4. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  5. Investing

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money. Learn about the relationship between rates and stocks.
  6. Financial Advisor

    Understanding Internal Rate Of Return

    Internal rate of return, or IRR, is one of the most popular methods of evaluating potential projects. Learn more about this important metric.
  7. Personal Finance

    A project manager's qualifications and career path

    Learn about a project manager's job, the qualifications necessary for the position, and the most common careers for these professionals.
  8. Investing

    Internal Rate of Return Formula for Excel

    The internal rate of return, or IRR, is a popular metric businesses use to measure a project’s return on investment.
  9. Investing

    Return on investment versus internal rate of return

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
RELATED FAQS
  1. The Difference Between Hurdle Rate and High Water Mark

    Find out the difference between hurdle rates and high water marks. Learn how they are used by hedge funds to calculate incentive ... Read Answer >>
  2. How do you use discounted cash flow to calculate a capital budget?

    Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and internal rate ... Read Answer >>
  3. Which is better for capital budgeting – IRR or NPV?

    All other things being equal, using IRR and NPV measurements to evaluate projects often results in the same findings. However, ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center