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 less risky.
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 expected rate of return is above the hurdle rate, the investment is sound. If the rate of return falls below the hurdle rate, the investor may choose not to move forward. Some may also call a hurdle rate a break-even yield.
In capital budgeting, projects are evaluated either by discounting future cash flows to the present by the hurdle rate, to determine the net present value of the project or by computing the internal rate of return 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 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 preference toward a project. By assigning an appropriate risk factor, one can use the hurdle rate 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 percent for acceptable projects would most likely accept a project if it has an internal rate of return of 14 percent and does not have a significantly higher risk. Alternately, discounting the future cash flows of this project by the hurdle rate of 10 percent 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 regarding the completion of the project, the hurdle rate is a non-factor. Regardless of the risks or anticipated returns, mandated projects move forward to assure compliance with any applicable laws or regulations.