The hurdle rate is the minimum rate of return a business requires on a capital project.
Capital projects such as investment in a new piece of equipment, require a business to carry out an appraisal to assess whether the investment will produce sufficient return to justify the level of expenditure. This appraisal is usually carried out using discounted cash flow techniques to calculate the rate of return which produces a net present value of zero, referred to as the internal rate of return or IRR.
To evaluate the project the calculated internal rate of return is compared to the hurdle rate set by the business. Assuming there are no other limiting factors, if the projects internal rate of return is greater than the hurdle rate then the project should go ahead, on the other hand, if the projects internal rate of return is less than the hurdle rate the project should not proceed.
Hurdle Rate Formula Example
If a business plans to invest in a new piece of equipment costing 20,000, and expects to save 5,000 a year for the next 5 years, then the internal rate of return of the project is given by the Excel RATE function as follows:
Internal rate of return = RATE(5,5000,-20000) Internal rate of return = 7.93%
If the business has set itself a hurdle rate of 10% then the internal rate of return is less than the hurdle rate and the project should not go ahead.
On the other hand, if the cost savings from the project continued for 6 years instead of 5, then the internal rate of return can be recalculated as follows:
Internal rate of return = RATE(6,5000,-20000) Internal rate of return = 12.98%
In this case, the internal rate pf return of the project is greater than the hurdle rate set by the business and the project should proceed.
How to Calculate Hurdle Rate
A business will always want to earn more that it has to pay for its capital (both debt and equity), and therefore the minimum hurdle rate required will be its weighted average cost of capital. As different projects will have different levels of risk, the hurdle rate will usually be higher than the weighted average cost of capital (WACC) by perhaps 3-5%, and will reflect the level of risk involved. Alternatively, the hurdle rate could be set at the rate at which the business can borrow from the bank or at the average 5 year return from a stock index.
For further information see the Wikipedia Hurdle Rate definition.
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