Hurdle Rate Definition with Example
Hurdle Rate Definition – “A company’s minimum required rate of return on its investments”.
Hurdle rate is also the part of capital budgeting. It is the minimum rate that a company expects to earn from investing in a certain project. Therefore it is also known as target rate or the organization’s required rate of return. The most important thing is that the hurdle rate should be either equal to or more than internal rate of return.
In most cases, the minimum hurdle rate is equals to the cost of capital. But of the risk associated with the project is high then the hurdle rate increases. So investors always considers those projects which provides return more than hurdle rate and rejects projects and investment whose returns are less than the hurdle rate. Because of this reason, it is also called as break – even yield.
Hurdle Rate Example
Let’s discuss an example to understand hurdle rate definition more clearly. ABC Ltd is deciding whether to go for a new project or not. The investments requirement is Rs. 10,00,000. It is expected that the project will generate 2,00,000, 2,50,000, 3,00,000,2,50,000 cash inflows for next 4 year respectively. The minimum hurdle rate is 10%. Now company decides if it has IRR of 12% it will accept the project.
Related Financial Terms of Hurdle Rate
- Economic Value Added Definition – EVA Meaning with Example
- Net Present Value Definition – NPV Formula and Example
Importance of Hurdle Rate – Why Hurdle Rate is Used?
Hurdle Rate plays an important role while taking a new project or going for a new investment opportunity. If the IR is more than hurdle rate, then organizations accept the project or vice versa.
However, it is not advisable to compare the investments just on the basis of the percentage return it is providing. Other factors such as risk and cost of capital should also kept in mind while making any decision. Meaning thereby, one can loose the larger projects which can provide sound earnings to the investors just because their hurdle rate is not good.
But projects that requires any kind of legal requirements completely ignore the hurdle rate. Leaving risks and anticipated returns behind, these projects main motive is to comply with the laws and regulations.