Hurdle Rate
Candlefocus EditorA hurdle rate acts as a gateway to enter into a project while managing the risk and reward associated with it. It is a measure of required compensation for assuming the risks that come with an investment. A company’s weighted average cost of capital (WACC) is generally taken as the hurdle rate for a particular investment or project.
Using a hurdle rate is beneficial for a company as it helps quantify the estimated return from a certain project. If the anticipated return from a project is higher than the hurdle rate, then the expected return is greater than the cost of capital and the business deal is accepted.
Discounted cash flow analysis is used to arrive at the net present value of an investment to calculate its worth. It considers the time value of money and calculates the expected returns in terms of cash flows at an interest rate. The interest rate chosen by investors serves as the hurdle rate.
The higher the hurdle rate, the greater the risk of the investment which in turn significantly affects the decision-making process of the investor. If returns look promising, then the investors are ready to take the risk and move forward with the project. The hurdle rate of a project can be lowered by managing the existing risks through careful risk assessment.
In a nutshell, the use of a hurdle rate provides investors with a framework to assess whether a project has the potential to generate returns higher than the required rate of return that they have set. This helps them determine whether they should move forward with the project.