Hurdle Rate
What is hurdle rate?
The hurdle rate is the minimum return that an investor expects to earn from an investment. It serves as a benchmark for determining whether a project or investment is financially viable.
Calculation of Hurdle Rate
The hurdle rate is often based on the company's weighted average cost of capital (WACC), which includes the cost of debt and the cost of equity. The rate may also incorporate a risk premium to account for the uncertainty associated with the project. For instance, a high-risk project might have a higher hurdle rate to compensate for the increased risk.
Risk Premium and Hurdle Rate
When setting the hurdle rate, it's important to add a risk premium. This is an extra amount added to account for the risk involved in the investment. For projects with higher risk, the hurdle rate is increased to ensure the potential returns are sufficient to compensate for the extra risk.
Hurdle Rate vs. Required Rate of Return
While the hurdle rate and the required rate of return (RRR) are often used interchangeably, they can differ. Management typically establishes the hurdle rate as a benchmark for assessing investments, whereas the required rate of return (RRR) represents the minimum return an investor anticipates, considering the investment's level of risk. Both serve to ensure that investments are made wisely, but the hurdle rate is more focused on meeting or exceeding corporate financial objectives.
Importance in Investment Decisions
The hurdle rate is crucial in capital budgeting decisions. Companies use it to evaluate potential projects or investments. If the expected return on a project exceeds the hurdle rate, it is considered for approval. Projects that do not meet or exceed the hurdle rate are typically rejected, as they may not generate enough return to justify the risk.
Impact on Business Strategy
The hurdle rate influences a company's strategic decisions by determining which projects align with its financial goals. By setting an appropriate hurdle rate, companies can prioritize investments that contribute to long-term growth and profitability while avoiding those that may not generate sufficient returns.
