Hurdle Rate (Finance) - Explained
What is a Hurdle Rate?
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Table of ContentsWhat is a Hurdle Rate?How Does a Hurdle Rate Work?Example of How to Use a Hurdle Rate
What is a Hurdle Rate?
A hurdle rate, also called a break-even yield is the minimum acceptable rate of return on investment (ROI) that is mandated by an investor or a fund manager as a form of compensation for the risks undertaken because of making that investment. As a rule of thumb, the higher the risks undertaken, the higher is the hurdle rate. In high-risk investments such as hedge funds, investors actually make it mandatory for fund managers to beat hurdle rates in order to be eligible to collect incentive fees.
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How Does a Hurdle Rate Work?
A hurdle rate is an effective comparison tool that pitches the merits of the investment in question against the associated risks in order for the investor or fund manager to be able to decide whether or not to proceed with the investment. A sound investment will always have a return on investment higher than the hurdle rate. An ROI below the hurdle rate will obviously thwart the investor from making that investment, saving him/her from potential loss. This kind of rate of return predictions for investments comes in handy during capital budgeting, where important investment decisions are taken based on calculations of internal rate of ROIs of proposed investments.
Example of How to Use a Hurdle Rate
Every asset carries with it a risk premium, which is a value that indicates the estimated amount of risk associated with a potential investment. By the rule of thumb, the higher the risk, the higher is the risk premium, and vice versa. It is but natural human behavior for investors to sometimes be biased toward a project that may seem lucrative at first glance. Applying a hurdle rate to assess underlying risks and pitching them against potential gains can greatly assist in making a final decision regarding whether or not to go ahead with the investment. Let us assume a business mandates a standard hurdle rate of 15 percent for a new undertaking. Given that a new venture has an internal rate of return of investment of 20 percent, the business will, in all probability go ahead with the investment, unless there exist any significant underlying risks. Consecutively, this project will also bring in returns in the form of liquidity which when adjusted for a 15 percent hurdle rate, will still promise a high net present value. This should guarantee investor confidence in the venture. However, there are instances where a hurdle rate is insignificant, for example, in circumstances where laws mandate the completion of the project. In such cases, it becomes unnecessary to pitch risks against potential gains.