A hurdle rate is the minimum required rate of return or target rate that investors anticipate to obtain on an investment, commonly referred to as the minimum acceptable rate of return (MARR). The rate is established by evaluating the cost of capital, risks present, existing business expansion potential, rates of return for comparable projects, and other variables that may have an immediate impact on an investment.
An investment project's internal rate of return (IRR) must be at least as high as the hurdle rate before it can be accepted and put into action. For any possible investments to be considered over the long term, their return rate must be higher than the hurdle rate.
Hurdle Rate Usage
A risk premium is frequently applied to a potential investment to indicate the expected level of risk involved. The risk premium should rise as the risk increases because it takes into account the idea that as the risk of losing your money increases, so should the return on your investment. The WACC is frequently compounded with a risk premium in order to obtain a higher hurdle rate.
An investment's potential can be evaluated using a hurdle rate, which eliminates any bias resulting from favoritism for a specific project. By assigning the right risk factor, an investor can use the hurdle rate to demonstrate if the project has financial merit regardless of any assigned intrinsic value.
Hurdle Rate Example
Let's look at a condensed illustration. Hammer Industries wants to buy a new piece of equipment. It predicts that by increasing sales of hammers with this new piece of equipment, it will earn an 11% return on investment. The firm's WACC is 5%, and as there is little chance that more hammers won't be sold, a low-risk premium of 3% is assigned. then, the hurdle rate is:
WACC (5%) + Risk premium (3%) = 8%
The new piece of equipment would be a wise investment because the hurdle rate is 8% and the anticipated return is greater at 11%.
Why Is Hurdle Rate Important?
In the business world, a hurdle rate, sometimes referred to as a break-even yield, is essential, especially when it comes to new initiatives and projects. A project's level of risk determines whether or not a corporation chooses to take it on. If the expected rate of return surpasses the hurdle rate, the investment is deemed sound. The investor may decide not to proceed if the rate of return is lower than the hurdle rate.
What Are the Disadvantages of Hurdle Rate?
Hedge rates frequently favor projects or investments that have high rates of return on a percentage basis, despite the fact that the cash value is smaller. Furthermore, picking a risk premium is challenging because the value is uncertain. If a project or investment is chosen incorrectly, it may yield greater or lesser returns than expected, resulting in the waste of resources or the loss of opportunities.
How Is a Hurdle Rate Determined?
To arrive at the project's net present value (NPV), businesses can discount the cash flows using any hurdle rate they like. The project will be approved by the corporation if the NPV is favorable. However, the majority of businesses set the hurdle rate as their weighted average cost of capital (WACC), which is the whole required return.
- An investment or project's hurdle rate is the lowest rate of return required.
- Business owners might use hurdle rates to determine whether to move forward with a project.
- More risky initiatives are often associated with higher hurdle rates, whilst less risky ventures are typically associated with lower rates.
- Investors determine an investment's net present value to determine its value by applying a hurdle rate to a discounted cash flow analysis.
- Businesses commonly utilize the hurdle rate as their weighted average cost of capital (WACC).