Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Hurdle Rate

What it is:

A hurdle rate is an investor's minimum rate of required return on an investment.

How it works (Example):

Let's assume Company XYZ is deciding whether to purchase a piece of factory equipment for $300,000. The equipment would last only three years, but it is expected to generate $150,000 of additional profit per year during those years. Company XYZ also thinks it can sell the equipment for scrap afterward for about $10,000. The company needs to determine whether the purchase is a better use of cash than some of Company XYZ's other investment options, which return about 10% (its hurdle rate).

Why it Matters:

A hurdle rate is the "line in the sand" that helps companies decide whether to pursue projects. Companies often use internal rate of return (IRR) to determine whether an investment exceeds a company's hurdle rate. Regardless of the calculation method, it is important to note that judging a project based on percentage returns can be dangerous. Hurdle rates can favor investments with high rates of return even if the dollar amount of the return is very small, for instance, and they can reject larger projects even though they may generate more cash for the investor. Thus, a $1 investment returning $3 will look more favorable than a $1 million investment returning $2 million.

It is also important to note that cash flows cannot always be reinvested at the project's rate of return. This is not always a realistic assumption, especially for investments with an unusually high return.