In: Accounting
In using Capital budgeting method that takes the time value of money into consdieration, management must consider a hurdle rate in making its decision. What is the hurdle rate? What factors does management have to consider in selecting a hurdle rate?
In capital budgeting, hurdle rate is the rate used to discount future cash inflows to current worth. Hurdle is also known as Minimum Acceptable Rate of Return (MARR) or Target Rate (TR) or Minimum Required Rate of Return (MRRR). Hurldle rate serves as the tool for comparison whether project's Internal Rate of Return (IRR) exceeds the hurdle rate or equals the hurdle rate because if project's IRR is less than hurdle rate, it shall be rejected.
Factors that shall be considered before determining suitable hurdle rate include:
--> Firm's existing weighted average cost of capital (WACC)
--> Risks involved in the project execution
--> Current opportunities foregone in existing business expansion, by choosing the project
--> Expected Rate of Return for similar investments that the firm handles
--> Other factors that could directly affect an investment such as Risk premium, Inflation rate and Market Interest rate.
Using the hurdle rate thus determined, a project can be evaluated using various capital bugeting evaluation tools involving discounting future cash flows to current worth such as Net Present Value (NPV), Profitability Index (PI), Discounted Payback Period (DPP), Discounted Cash Flows (DCF) model, etc.