Hurdle Rate

Before accepting and funding an investment project, the rate of return must be determined by setting a minimum rate called a hurdle rate.

What is a Hurdle Rate?

A hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive from their investing activities. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rate of return for investments, and other factors that could directly affect an investment. Before accepting and implementing a certain investment project, its internal rate of return (IRR) should be equal to or greater than the hurdle rate. However, most importantly, any potential investments must have a return rate that is higher than the hurdle rate in order for it to be acceptable in the long run.

What are the Methods Used in Determining the Hurdle Rate?

  • Discounted cash flow (DCF) – this is the most common method used to evaluate a hurdle rate. This method uses the concept, time value of money, by which all future cash flows are estimated and discounted through using the cost of capital to provide the net present value.
  • Internal rate of return/ cost of capital – this is the weighted average of after tax costs for long-term debt, common stock, and preferred stock. It is usually the base line of a hurdle rate.
  • Capital asset pricing model – estimates the risk-adjusted hurdle rate for an investment project. This considers the two risks involved in big ventures, such as: systematic risk and unsystematic risk.

What are the Factors to Consider When Using a Hurdle Rate?

In analyzing a potential investment, a company must first hold a preliminary evaluation to test if a project has a positive net present value. Care must be exercised as setting a very high rate could be a hindrance to other profitable projects and could also favor short term investments over the long-term ones. A low hurdle rate could also result in an unprofitable project.

  • Risk premium – assigning a risk value for the anticipated risk involved with the project. Riskier investments generally have greater hurdle rates than less risky ones.
  • Inflation rate – if the economy is experiencing a mild inflation, it may influence the final rate by 1-2 percent. There are instances when inflation may be the most significant factor to consider.
  • Bank interest rate – the interest accumulated from borrowing money from a bank’s line of credit to fund the investment.

How Important is the Hurdle Rate in Capital Investments?

The hurdle rate is often set to the weighted average cost of capital (WACC), also known as the benchmark or cut-off rate. Generally, it is utilized to analyze a potential investment, taking the risks involved and the opportunity cost of foregoing other projects into consideration. One of the main advantages of a hurdle rate is its objectivity, which prevents management accepting a project based on non-financial factors. Some projects get more attention due to popularity, while others involve the use of new and exciting technology.

What are the Limitations of Using a Hurdle Rate?

  • Hurdle rates can favor investments with high rates of return, even if the amount is very small, and it can reject bigger projects, although they may generate more cash for the investors.
  • Being overly conservative may be one limitation of hurdle rates.
  • Cost of capital is usually the basis of a hurdle rate and it may change over time.

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