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The hurdle rate is the minimum acceptable rate of return on an investment that must be achieved before an investment or project is considered financially viable. It’s used to assess the viability of a potential investment.
Here’s what else you need to know about hurdle rates, including how they’re calculated, why they matter and their limitations.
How to calculate the hurdle rate
The formula for calculating the hurdle rate is based on the cost of capital and risk premium.
Hurdle rate: weighted average cost of capital + risk premium
Weighted average cost of capital (WACC): The WACC is a calculation that determines the cost incurred by a company to obtain capital. It represents the amount that the company must repay to its investors for each dollar it raises. In other words, it’s the cost to raise money after accounting for debt and taxes.
Risk premium: The risk premium accounts for the potential failure of the investment. It’s found by subtracting the return on a risk-free investment (usually the rate on a zero-coupon Treasury bond is used). For example, if company EX had a return of 9 percent and the U.S. Treasury 3-month yield is 5 percent, the risk premium is 4 percent.
An example of how to calculate the hurdle rate
If an investor’s cost of capital is 7 percent and the risk premium for a specific investment is 4 percent, the hurdle rate would be 11 percent.
Weighted average cost of capital + risk premium = hurdle rate
7% + 4% = 11%
Keep in mind the inflation rate can affect the calculation of the hurdle rate because it reduces the purchasing power of money. Changes in interest rates set by the Federal Reserve can also impact the risk-free rate, which is used to calculate the risk premium.
How is the hurdle rate used and why does it matter?
There are a few critical reasons why the hurdle rate matters to businesses. For starters, companies need an objective method to evaluate investments. Having a hurdle rate helps prevent decisions based on non-financial factors. For management teams or private equity firms looking to evaluate potential investments, the hurdle rate serves as a benchmark. They use the hurdle rate to discount cash flows and calculate the net present value, which can help determine if a project is viable. In acquisitions, the acquirer sets a hurdle rate to determine if there is a favorable difference between the hurdle rate and the sum of the target company’s cost of capital and their risk premium.
The hurdle rate can also help investors assess the level of risk. If you’re an investor, you may also want to consider an investment’s cost of capital and risk premium in addition to its return. The hurdle rate increases with the level of risk in an investment, so the risk premium should be higher for investments with a higher level of risk.
Hurdle rate limitations
The hurdle rate is a useful tool for evaluating investment opportunities, but it also has some potential drawbacks. For starters, relying on the hurdle rate alone can lead to inefficient use of funds or missed opportunities if the project or investment returns more or less than expected. For example, a project yielding a 20 percent return may be passed over for one with a 30 percent return. However, the net present value (NPV) of the 20 percent project may be higher than that of the 30 percent project, even though the percentage return is lower. The hurdle rate doesn’t account for this.
Another hurdle rate limitation is determining a suitable risk premium for the calculation as it can be challenging to measure the risk of an investment precisely.
Hurdle rates also prioritize projects or investments with higher percentage-based returns, which means opportunities that have a lower percentage-based return but net more money may be overlooked.
When considering investments, the hurdle rate is important for understanding the minimum rate of return required for a project or investment to be tenable. The hurdle rate is just one of many factors to consider before making an investment.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.