Hurdle Rate - Explained
What is a Hurdle Rate?
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Table of ContentsWhat is a Hurdle Rate?How to Determine the Hurdle Rate?How to Use a Hurdle RateKEY TAKEAWAYS
What is a Hurdle Rate?
A Hurdle Rate refers to the least rate of return expected on an investment or project. It is the minimum return that managers and investors expect on a project. The amount of risk present in an investment or project often informs the hurdle rate, if the project has many risks, the hurdle rate is expected to be high and if it has less risk, the hurdle rate will be low. A hurdle rate is the minimum acceptable rate of return (Marr). This is the return managers target to realize and the return investors expect to receive on an investment.
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How to Determine the Hurdle Rate?
Hurdle rates help businesses make important decisions as to which project to embark on, investors also use hurdle rates in making investment decisions. When the expected rate of return on an investment is higher than the hurdle rate, such investment is profitable but has higher risk. If the rate of return is less than the hurdle rate, such an investment or project is not sound. The success of a project can be examined using two approaches. The first is using the net present value (NPV) of the project. A project with positive NPV gets a quick approval while a negative NPV causes decline of the project. The second approach is using the internal rate of return (IRR) of the project in relation to the hurdle rate. A project whose IRR is higher than the hurdle rate has more chances of success than when the IRR is less than the hurdle rate.
How to Use a Hurdle Rate
There are four major factors that must be considered when determining the hurdle rate of a project. These are the cost of capital, risks of the project, return for similar projects or investments and other factors that affect the investment. Using a hurdle rate entails assigning adequate risk for an investment so that through the hurdle rate, the success of profitability of the investment can be determined. The expected amount of risk in an investment is known through a risk premium. Negative risk premium give an assurance of minimized risk in an investment while positive risk premium denote that the investment has high risk. There are some exceptions to the use of hurdle rates, companies that embark on mandatory projects tend not to use the hurdle rate because whether used or not, the project must be executed.
Here are some important things to know about hurdle rate;
- A hurdle rate is the minimum rate of return expected on a project by managers and on an investment by investors.
- Hurdle rates are important factors that determine whether a company will embark on a project or otherwise.
- The viability of a project can be evaluated using either the net present value (NPV) approach or the internal rate of return (IRR) method.
- Projects with higher hurdle rates have more risks while those with low hurdle rates have less risks.