Question

What is a hurdle rate? Are there other names for this concept? How is the hurdle rate calculated, and how is it used in managerial decisions making?

Answer 1

A hurdle rate is the minimum rate of return required on the investment. The other name for this is minimum rate of return, cost of capital or cut off rate. A hurdle rate is usually a cost of capital. The cost of capital can be based on source of finance. If the money is sourced though debt the cost of debt is hurdle rate. If the money is sourced through mix of debt and equity a weighted average cost of capital can be considered as a hurdle rate. A hurdle rate is widely used in capital budgeting decision making. Capital budgeting are the budgets done to evaluate capital investments. They are long term in nature and irreversible. A hurdle rate helps in managerial decision making in following ways

· The hurdle rate is the minimum rate of return required on projects

· It helps in stockholders wealth maximisation since projects with minimum return is accepted.

· The annual cash flows are discounted to present value based on the hurdle rate.

· If the present value of cash inflows is higher than present value of cash outflows the investment is accepted

· If the present value of cash inflows is lower than the present value of cash outflows the investment is rejected

· When internal rate of return is computed, if IRR is above the hurdle rate the project is accepted else the project is rejected.