What is the hurdle rate?
The hurdle rate is the minimum return that an investor or manager expects for an investment. It therefore provides an investor or a company with information on whether a particular investment is worthwhile. Only if the project or investment has the potential to achieve the hurdle rate will the investment be considered. The hurdle rate is higher for investments with a higher risk, as the investor wants to be compensated for the risk. The hurdle rate therefore takes into account the risk of an investment. Furthermore, the cost of capital and the income from other possible investments are taken into account. The inflation rate and the interest rate also play a role. While inflation can reduce the return in the future, the interest rate represents opportunity costs.
In the business world, the hurdle rate is important when it comes to selecting the right investments. If the expected return is above the hurdle rate, the investment is eligible. However, if the expected return is below the hurdle rate, the investment does not meet the desired criteria. The hurdle rate is therefore a break-even return, i.e. the return above which it is worth making the investment.
Application of the hurdle rate
The profitability of a project is generally determined using two methods . One is the discounted cash flow analysis (DCF) and the other is the internal rate of return (IRR).
In the DCF method, cash flows are discounted using a specific interest rate. This interest rate represents the hurdle rate, i.e. the minimum return that the company or investor would like to achieve. The cash flows are discounted at the hurdle rate and added together. The value is then compared with the total costs of the project. If the total costs of the project are deducted from the sum of the discounted cash flows, this gives the net present value of the project. If this value is positive, the investment in the project is worthwhile. With this method, companies very often use their weighted average cost of capital (WACC) as the hurdle rate. As a rule, a risk premium is added to take into account the risks of a particular investment.
The second method for determining the profitability of a project is the IRR method. The IRR is the discount rate at which the net present value (NPV), i.e. the sum of the discounted cash flows, is equal to zero. The IRR is therefore the rate of return at which the net present value is zero. The IRR is then compared with the hurdle rate. If the IRR is higher than the hurdle rate, the project is profitable.
Advantages and disadvantages of the hurdle rate
One advantage of the hurdle rate is that it helps management to assess an investment objectively, based on figures. The aim is to prevent investments being made solely on the basis of non-financial factors. For example, investments that are currently in vogue or more highly regarded are generally given more attention.
One disadvantage of the hurdle rate is that it only refers to the potential return as a percentage, but not to the amount of money invested. Depending on how much money is to be invested and what alternatives are available, an investment with a lower percentage return but a higher return in monetary units (higher investment amount) may be more suitable. Calculating the right risk premium for an investment is also very complicated. The risk can only be estimated.