INVESTING

INVESTING ESSENTIALS

Hurdle Rate
By
WILL KENTON
|
Reviewed by
MICHAEL J BOYLE
|
Updated Mar 22, 2021

What Is Hurdle Rate?

A hurdle rate is the minimum rate of return on a project or investment required by a manager
or investor. It allows companies to make important decisions on whether or not to pursue a
specific project. The hurdle rate describes the appropriate compensation for the level of risk
present—riskier projects generally have higher hurdle rates than those with less risk. In order
to determine the rate, the following are some of the areas that must be taken into
consideration: associated risks, cost of capital, and the returns of other possible investments
or projects.

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KEY TAKEAWAYS
A hurdle rate is the minimum rate of return required on a project or investment.
Hurdle rates give companies insight into whether they should pursue a specific
project.
Riskier projects generally have a higher hurdle rate, while those with lower rates
come with lower risk.
Investors use a hurdle rate in a discounted cash flow analysis to arrive at the net
present value of an investment to deem its worth.
Companies often use their weighted average cost of capital (WACC) as the hurdle
rate.
Hurdle Rate

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Understanding Hurdle Rate

Hurdle rates are very important in the business world, especially when it comes to future
endeavors and projects. Companies determine whether they will take on capital projects
based on the level of risk associated with it. If an expected rate of return is above the hurdle
rate, the investment is considered sound. If the rate of return falls below the hurdle rate, the
investor may choose not to move forward. A hurdle rate is also referred to as a break-even
yield.
There are two ways the viability of a project can be evaluated. In the first, a company decides
based on the net present value (NPV) approach by performing a discounted cash flow (DCF)
analysis.

Cash flows are discounted by a set rate, which the company chooses as the minimum rate of
return needed for an investment or project; the hurdle rate. The value of the discounted cash
flows depends on the rate used in discounting them. The overall cost of the project is then
subtracted from the sum of the discounted cash flows using the hurdle rate to arrive at the
net present value of the project. If the NPV is positive, the company will approve the project.
Often companies use their weighted average cost of capital (WACC) as the hurdle rate.

In the second method, the internal rate of return (IRR) on the project is calculated and
compared to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely
proceed.
Hurdle Rate Usage
Often, a risk premium is assigned to a potential investment to denote the anticipated
amount of risk involved. The higher the risk, the higher the risk premium should be, as it
takes into consideration the fact that if the risk of losing your money is higher, so should the
return on your investment be higher. A risk premium is typically added onto the WACC to
arrive at a more appropriate hurdle rate.

Using a hurdle rate to determine an investment's potential helps eliminate any bias created
by preference toward a project. By assigning an appropriate risk factor, an investor can
use the hurdle rate to demonstrate whether the project has financial merit regardless of any
assigned intrinsic value.

For example, a company with a hurdle rate of 10% for acceptable projects would most likely
accept a project if it has an IRR of 14% and no significant risk. Alternatively, discounting the
future cash flows of this project by the hurdle rate of 10% would lead to a large and positive
net present value, which would also lead to the project's acceptance.

Hurdle Rate Example

Let's take a look at a simplified example. Amy's Hammer Supply is looking to purchase a new
piece of machinery. It estimates that with this new piece of machinery it can increase its
sales of hammers, resulting in a return of 11% on its investment. The WACC for the firm is 5%
and the risk of not selling additional hammers is low, so a low risk premium is assigned at
3%. The hurdle rate is then:

WACC (5%) + Risk premium (3%) = 8%

As the hurdle rate is 8% and the expected return on the investment is higher at 11%,
purchasing the new piece of machinery would be a good investment.

Disadvantages of a Hurdle Rate

Hurdle rates typically favor projects or investments that have high rates of return on a
b i if h d ll l i ll l j h f
percentage basis, even if the dollar value is smaller. For example, project A has a return of
20% and a dollar profit value of $10. Project B has a return of 10% and a dollar profit value of
$20. Project A would most likely be chosen because it has a higher rate of return, even
though it returns less in terms of overall dollar value.

In addition, choosing a risk premium is a difficult task as it is not a guaranteed number. A

project or investment may return more or less than expected and if chosen incorrectly, this
can result in a decision that is not an efficient use of funds or one that results in missed
opportunities.

Frequently Asked Questions

Why Is Hurdle Rate Important?
A hurdle rate, also referred to as a break-even yield, is very important in the business world,
especially when it comes to future endeavors and projects. Companies determine whether
they will take on capital projects based on the level of risk associated with it. If an expected
rate of return is above the hurdle rate, the investment is considered sound. If the rate of
return falls below the hurdle rate, the investor may choose not to move forward.

What Are the Disadvantages of Hurdle Rate?

Hurdle rates typically favor projects or investments that have high rates of return on a
percentage basis, even if the dollar value is smaller. Additionally, choosing a risk premium is
a difficult task as it is not a guaranteed number. A project or investment may return more or
less than expected and if chosen incorrectly, this can result in a decision that is not an
efficient use of funds or one that results in missed opportunities.

How Is a Hurdle Rate Determined?

Companies can choose an arbitrary hurdle rate to discount the cash flows to arrive at the net
present value (NPV) of the project. If the NPV is positive, the company will approve the
project. However, most companies add a risk premium to their weighted average cost of
capital (WACC), which is the overall required return, and set that as the hurdle rate.

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Related Terms
Related Terms

Internal Rate of Return (IRR)

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the return of
potential investments.
more

Cost of Capital
Cost of capital is the required return a company needs in order to make a capital budgeting project,
such as building a new factory, worthwhile.
more

Discounted Cash Flow (DCF)

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity.
more

How to Calculate the Weighted Average Cost of Capital – WACC

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each
category of capital is proportionately weighted.
more

Net Present Value (NPV)

Net Present Value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time.
more

Internal Rate of Return (IRR) Rule Definition

The internal rate of return (IRR) rule is a guideline for evaluating whether a project or investment is
worth pursuing.
more

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