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hurdle rate

Also called: required rate of return, minimum acceptable rate of return

The minimum return a project must beat to be worth doing, usually the cost of capital plus a premium for extra risk.

A hurdle rate is the minimum return a project must beat to be worth doing. It is the discount rate a company uses for that kind of bet: a project passes if its NPV at the hurdle rate is positive, which for an ordinary project is the same as its IRR being above the hurdle.

It usually starts from the cost of capital, what the company's money costs on average, and adds a premium for risk above average. Cutting a known bill is safer than launching a new feature, and a new market (new customers, new sales, a new currency) is riskier still. A simple policy names a few tiers, for example 25% for efficiency projects with known costs, 30% for product bets on current customers and 40% for new markets.

One rate for everything quietly tilts the portfolio: risky bets look better than they are, safe ones look worse, and the company drifts into risk without anyone deciding to. A rate set too high is just as wrong; it kills good bets more quietly. And the hurdle prices risk only: if the forecast looks rosy, fix the cash flows or test scenarios instead of adding points to the rate.

Example

Klasna's cost of capital is 25%, and its policy sets three hurdles: 25% for efficiency, 30% for product bets, 40% for new markets. Launching Klasna for Teams in Poland costs 2,000,000 UAH and brings 500,000, 900,000, 1,200,000 and 1,200,000 over four years.

At 25%: −2,000,000 + 400,000 + 576,000 + 614,400 + 491,520 = +81,920 UAH. At its own 40% hurdle: −433,985.84 UAH. Its IRR is 26.97%: above the company average, far below the risk of a new country.

The other way round, the maths mock-exam mode (a product bet) is worth +30,033.96 at its 30% hurdle but −179,800.08 if it were judged at 40%. The right rate is the one that matches the bet.

Common mistakes

  • One rate for every bet. New markets pass too easily and safe efficiency projects fail.
  • Using the loan rate. The bank finances only part of the company, and it is paid first; the owners' money costs more.
  • Padding the rate "to be safe". Too high a hurdle rejects good bets; it loses money more quietly.
  • Raising the rate to fix a rosy forecast. The hurdle prices risk; doubtful cash flows are fixed in the forecast or in scenarios.
  • Choosing the tier after seeing the result. Classify the bet first, then compute.

Learn it in the course