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. Hurdle rates allow companies to make important decisions on whether to pursue a specific project.
The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk.
In order to determine the rate, the following must be taken into consideration: risks, cost of capital, returns for similar investments, and anything else that may affect the investment.
In hedge funds, the hurdle rate refers to the rate of return the fund manager must beat before collecting incentive fees.
Understanding Hurdle Rates
Hurdle rates are very important in the business world, especially when it comes to future endeavors 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.
There are two ways the viability of a project can be evaluated. In the first, a company decides based on the net present value (NPV) approach. Cash flows are discounted by a set rate. The value of the discounted rate depends on the rate used in discounting future cash flows. That rate is the hurdle rate. The overall cost of the project is then subtracted from that rate to get the net present value of the project. If the NPV is positive, the company will approve the project.
In the second method, the internal rate of return (IRR) on the project is calculated and compared to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely proceed.
How to Use a Hurdle Rate
A risk premium is assigned to a potential investment to denote the anticipated amount of risk involved. Risk premiums may be either positive or negative—negative rates help offset other factors that lessen the appeal of an investment if the risk is 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, an investor can use the hurdle rate to demonstrate whether the project has financial merit regardless of any assigned intrinsic value.
For example, a company with a hurdle rate of 10% for acceptable projects would most likely accept a project if it has an IRR of 14% and no significant risk. Alternatively, 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 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.
- A hurdle rate is the minimum rate of return required on a project or investment
- Hurdle rates give companies insight into whether it should pursue a specific project.
- Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower risk.