Hurdle rate definition

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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

Relying on a hurdle rate can have disadvantages that can impact decision-making and long-term strategy. Here are some notable drawbacks:

  • Overly conservative decision-making. Setting a high hurdle rate might lead to overly conservative decisions, causing potentially profitable projects to be rejected. This can be especially problematic for companies looking to grow or expand into new, riskier markets, as they may pass up valuable opportunities that could enhance their competitiveness.

  • Discourages risk-taking. By setting a high hurdle rate, companies may inadvertently discourage projects with a higher risk-return profile. Innovative projects, particularly in fields like technology and research, often carry higher risks but also high potential payoffs. High hurdle rates can prevent companies from pursuing these riskier, groundbreaking ventures.

  • Misalignment with strategic goals. The hurdle rate might prioritize financial return over strategic alignment. For example, projects that could yield low short-term financial returns but align with long-term goals (such as brand building, sustainability initiatives, or R&D) might be disregarded if they don’t meet the financial benchmark.

  • Hard to set the correct rate. Determining an appropriate hurdle rate can be challenging. Many companies base it on the cost of capital, but they may adjust it for additional risk factors, which can be subjective and arbitrary. Setting it too high can cause missed opportunities, while setting it too low can lead to poor investment choices.

  • Subjectivity in rate calculation. The choice of a hurdle rate may be subjective, as it often reflects management’s perception of risk and desired returns. This subjectivity can introduce variability and potential bias, as different managers may choose different rates based on personal risk tolerance or market outlook, leading to inconsistent decision-making.

  • Over-emphasis on short-term returns. The hurdle rate often emphasizes short-term financial returns, which might not fully capture the long-term value or benefits of an investment. This short-term focus can misalign with objectives that require sustained investment over a longer period, potentially undermining projects like infrastructure development or talent acquisition.

  • Over-emphasis on quantitative metrics. A hurdle rate may lead to over-reliance on quantitative financial metrics while ignoring qualitative factors that are crucial to the success of a project. For instance, projects that could improve employee morale, customer satisfaction, or brand reputation may be rejected because their benefits are harder to quantify in financial terms.

  • Potential for misallocation of capital. A fixed hurdle rate might not reflect differences in risk among various projects. Applying the same hurdle rate across all projects can lead to misallocation of capital, as it doesn’t distinguish between projects with different risk profiles. For example, applying the same rate to both a high-risk expansion project and a low-risk maintenance project can distort priorities.

In summary, while the hurdle rate can be a useful tool for filtering investments, its limitations suggest it should be used in conjunction with other decision-making criteria. By relying too heavily on a single quantitative metric, companies risk overlooking strategic, innovative, or long-term opportunities that could drive substantial growth and value.