A hurdle rate is the minimum rate of return required by a manager or investor on a project or investment. This allows companies to make critical choices about whether to follow a specific project or not.
The hurdle rate represents an acceptable reward for the present level of risk. It is riskier projects typically have higher hurdle rates than lower-risk ones.
How to Use a Hurdle Rate
Often, future investment is given a risk premium to reflect the expected amount of risk involved.
The higher the risk, the higher the risk premium will be, because it takes into account the fact that if the probability of losing your money is higher, the return on your investment will also be higher.
WACC for a more acceptable hurdle rate usually applies a risk premium.
Use a hurdle rate to assess the value of investment helps eradicate any prejudice generated by preference against a project.
Through determining an acceptable risk factor, an investor may use it to demonstrate that the project has financial merit irrespective of any intrinsic value applied to it.
For example, a business with a 10 percent hurdle rate for suitable projects will most likely approve a project if it has a 14 percent IRR and no significant risk.
Conversely, discounting this project’s potential cash flows by the 10 percent hurdle rate. It will result in a significant and optimistic net present value, which would also lead to project approval.
Disadvantages of a Hurdle Rate
Hurdle rates typically favor projects or investments that have percentage-based high rates of return, even when the dollar value is lower. Project A, for example, has a 20 percent return and a $10 million profit value. Project B has a 10 percent return and a $20 million profit value.
Therefore, it is a difficult task to select a risk premium, because it is not a guaranteed amount. A project or expenditure may return more or less than expected. And then, if wrongly selected, this can result in a decision that is not an effective use of the funds or that leads to missed opportunities.