Hurdle rate definition
/What is the Hurdle Rate?
The hurdle rate is the minimum rate of return required by an investor. It sets a threshold level for whether or not to invest cash in a project or investment. More specifically, the hurdle rate is the discount rate for which the cash flows of a proposed capital purchase must generate zero or positive discounted cash flows. The cash flows from a proposed project must at least equal zero when discounted using this rate, or else a company as a whole will generate a negative rate of return from the funds that it uses.
The hurdle rate is based on a company's cost of capital. The cost of capital is the blended cost to the business of obtaining funding from debt and equity. Thus, if the cost of capital is currently 12%, this is used as the hurdle rate.
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When to Use Multiple Hurdle Rates
It is possible that more than one hurdle rate will be used in the fixed asset proposal review process. Consider the alternatives noted below.
Legal Requirement
If a company is required by law to make an investment (such as for smokestack scrubbers), the hurdle rate does not apply at all, and cash flow discounting is irrelevant to the investment decision. The company must make the investment, no matter what the return from the investment may be.
Risky Outcome
If a proposed investment is considered to have an unusually risky outcome, the hurdle rate could be increased to reflect the higher degree of risk. This means that a risky project will only be accepted if it generates unusually high cash flows. An example of a risky investment is when the company is about to enter an entirely new market with which it is not familiar, and wants to invest funds in the construction of a production line for this market.
Advantages of a Hurdle Rate
The main advantage of using a hurdle rate is that it sets a quantitative limit on the types of projects that a management team can accept. Its use therefore keeps a business from investing in capital projects for which there is no financial justification. A likely outcome is that more cash is available for financially worthwhile projects, which eventually lifts the rate of return of the business as a whole.
Disadvantages of a Hurdle Rate
There are several issues with the use of a hurdle rate. First, this approach results in projects being approved that have a high percentage rate of return, but not necessarily a large dollar return; in short, smaller projects may be selected over larger ones. Second, adjusting a hurdle rate for risk represents a qualitative adjustment, and so is bound to be imprecise. It could result in a hurdle rate that does not efficiently allocate an investor’s funds.