What Is A Hurdle Rate?
Hurdle rate is a term used in finance and economics to refer to a specific rate of return that must be exceeded in order for a project to be deemed profitable. It is also known as the minimum acceptable rate of return. In essence, the hurdle rate is the minimum rate of return that must be achieved for a project or investment to be worthwhile.
How Is Hurdle Rate Calculated?
The hurdle rate is typically based on an investor’s risk tolerance and return expectations. The most common method of calculating a hurdle rate is to use the weighted average cost of capital (WACC). This is a measure of a company’s overall cost of capital incorporating the cost of both debt and equity. The WACC is then adjusted for the specific risk of the project being undertaken. For example, if a company’s WACC is 10%, and the project has a higher risk than the company’s overall risk profile, the hurdle rate could be set at 12%. This would mean that the project needs to generate a return of at least 12% in order to be deemed a success.
Applications of Hurdle Rate
Hurdle rates are commonly used in the following contexts:
- Investment Decisions: Hurdle rates are used to evaluate potential investments and help determine whether or not they are worth pursuing. If the expected rate of return is lower than the hurdle rate, the investment is generally not pursued.
- Business Decisions: Hurdle rates are also used in business decisions such as whether or not to launch a new product or enter a new market. The expected rate of return from the project must exceed the hurdle rate in order for the project to be pursued.
- Capital Budgeting Decisions: Hurdle rates are also used in capital budgeting decisions such as whether or not to pursue a capital project. If the expected return from the project does not exceed the hurdle rate, the project is usually not pursued.
Hurdle rates play an important role in financial decision making, helping to ensure that investments and other decisions are made with an eye towards generating a sufficient rate of return.
Conclusion
Hurdle rate is an important concept in finance and economics, used to determine whether or not a project or investment is worth pursuing. By setting a minimum rate of return, it helps ensure that investments and other decisions are made with an eye towards generating sufficient returns.
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