What is a ‘Hurdle Rate’
A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. The hurdle rate denotes appropriate compensation for the level of risk present; riskier projects generally have higher hurdle rates than those that are deemed to be less risky.
In hedge funds, the hurdle rate refers to the rate of return that the fund manager must beat before collecting incentive fees.
BREAKING DOWN ‘Hurdle Rate’
A hurdle rate functions as a parameter for comparison when determining the worthiness of a particular investment compared to the associated risk. If an anticipated rate of return is above the hurdle rate, the investment is considered to be sound. If the rate of return falls below the hurdle rate, the investor may choose not to move forward. A hurdle rate may also be referred to as a break-even yield.
In capital budgeting, projects are evaluated either by discounting future cash flows to the present by the hurdle rate, so as to ascertain the net present value of the project, or by computing the internal rate of return (IRR) on the project and comparing this to the hurdle rate. If the IRR exceeds the hurdle rate, the project would most likely proceed.
During the analysis of a potential investment, a risk premium is assigned to denote the anticipated amount of risk involved with the project in question. Risk premiums may be positive or negative, with negative rates helping to offset other factors that may make an investment look less appealing if the involved risk was not so low.
Using a hurdle rate to determine an investment’s potential helps eliminate any bias created by personal preference towards a project. By assigning an appropriate risk factor, the hurdle rate can be used to demonstrate whether the project has financial merit regardless of any intrinsic value that may be assigned.
Example Use of the Hurdle Rate in Investment Analysis
For example, a company with a hurdle rate of 10% for acceptable projects would most likely accept a project if it has an internal rate of return of 14% and does not have a significantly higher degree of risk. Alternately, discounting the future cash flows of this project by the hurdle rate of 10% would lead to a large and positive net present value, which would also lead to the project’s acceptance.
Exclusions to the Hurdle Rate Method
In situations where a legal requirement exists in regards to the completion of the project, the hurdle rate is deemed a non-factor. Regardless of the risks or anticipated returns, mandated projects move forward to assure compliance with any applicable laws or regulations.