What is a hurdle rate in finance?
A hurdle rate is the minimum acceptable rate of the required return on investment or project by an investor or a fund manager. It is also known as break-even yield. As a rule of thumb, the higher the risks undertaken, the higher is the hurdle rate. A healthy investment will always have a return on investment higher than the hurdle rate. If the return is less than the hurdle rate, then it is an indicator that the investor can stay away from making that investment and prevent making any potential loss.
The most commonly used method of calculating hurdle rate is:
Hurdle rate = Cost of capital (WACC) + Risk premium
The hurdle rate is usually compared to the internal rate of return, which the companies often evaluate while undertaking any investment or project like expansion plans or buying new plant/machinery. If the internal rate of return is more than the hurdle rate, the investment should be accepted, or else it should be denied.
To give you an example, a company XYZ is evaluating a project, and the hurdle rate is 6 per cent. If the return from the project is estimated to be 8 per cent, then the company can implement this project. However, if the return is 5 per cent, then the company should stay away from it.
The importance of the hurdle rate is that it creates a benchmark based on which an investor can make comparisons between various investment opportunities and take investment decisions more effectively. However, one limitation of the hurdle rate is that it usually hints at projects/investments, which have a high rate of return on a percentage basis, even if the total value is small.