What is a hurdle rate?
Hurdle rate refers to the lowest amount of rate that a company is likely to earn from the investment in a project. Therefore, in capital budgeting, hurdle rate is also recognized as the target rate or required rate of return of that company. It is essential for a project as its internal rate of return has to be equal or surpass the hurdle rate as it is necessary for the project to be approved.
Since the hurdle rate is the minimum rate of requisite return on investment, that minimum hurdle rate considered by the cost of capital of the company that is a combination of cost of debt and cost of equity. Whenever the company has lots of scopes for the investment opportunities and have several projects with higher risk, chances are there that the hurdle rate can be enhanced.
The hurdle rate is like the ‘line in the sand’ for companies as it assists them to decide whether they should pursue a project or not. The internal rate of return (IRR) is often used by the companies to find out if an investment will go beyond their hurdle rate.