The hurdle rate is a minimum rate of return or a specific level of profit that an investment or project must achieve to be considered acceptable. It is often used in capital budgeting where it is used as a cutoff point for determining whether to proceed with a project or investment.
The hurdle rate is typically determined based on the cost of capital, which is the return expected by those who provide financing for the company. This includes both equity holders (shareholders) and debt holders (creditors). It is important that a company’s investments generate returns above the hurdle rate to ensure it can meet its financial obligations and provide a return to its shareholders.
In many cases, the hurdle rate is set higher than just the cost of capital to account for the risk associated with a specific investment. The riskier the investment, the higher the hurdle rate. This way, companies only pursue projects that are expected to generate a return that is commensurate with the risk being taken.
If an investment or project has an expected rate of return that is higher than the hurdle rate, it may be considered a good investment. If the expected rate of return is lower than the hurdle rate, it may be deemed not worth the risk.
Example of the Hurdle Rate
Let’s imagine a company called GreenTech Energy is considering investing in a new solar power project.
The company’s overall cost of capital, which includes the cost of debt and the cost of equity, is 8%. This is the minimum rate of return the company must generate to satisfy its creditors and shareholders. Therefore, the cost of capital acts as the initial hurdle rate.
However, this solar power project is riskier than some of GreenTech’s other ventures. To account for this extra risk, the company decides to add a risk premium of 2% to the hurdle rate, making the project’s hurdle rate 10%.
The GreenTech financial team estimates that the solar power project will generate a 12% return on investment.
Since the projected return of 12% is higher than the hurdle rate of 10%, GreenTech Energy would likely decide to proceed with the project. The higher return indicates that the project should generate enough profit to cover the cost of capital and compensate for the risk taken, satisfying both debt holders and equity investors.
Of course, these numbers are simplifications, and in the real world, such calculations would also consider other factors such as taxes, cash flow timing, and more. Plus, a financial model would be used to run various scenarios to account for different possibilities and uncertainties.