A hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. 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. Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower risk.
The mathematical formula for the Hurdle Rate is the Weighted Average Cost of Capital (WACC) multiplied by the Risk Premium of a particular investment.
WACC= Weighted Average Cost of Capital Risk Premium. The risk premium is the return in excess of the risk-free rate of return that an investment is expected to yield.
The hurdle rate is often set to the weighted average cost of capital WACC, also known as the benchmark or cut-off rate. Generally, it is utilized to analyze a potential investment, taking the risks involved and the opportunity cost of foregoing other projects into consideration. The following present an example
of calculating the hurdle rate:
A hurdle rate is also referred to as a break-even yield.Hurdle rates
are very important in the business world, especially when it comes to future endeavors and projects. Individuals and 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.