What is the Hurdle Rate?

The hurdle rate is the minimum rate of return that an investment must achieve in order to be considered viable. It is used to evaluate investment opportunities and to determine whether an investment is likely to generate sufficient returns to justify the risks involved.

The hurdle rate is typically determined by an organization's cost of capital, which represents the minimum rate of return that must be achieved in order to cover the costs of funding the investment. The hurdle rate may also be adjusted to account for the level of risk associated with an investment, with higher-risk investments requiring a higher rate of return to be considered viable.

The hurdle rate is used in a variety of financial analyses, including discounted cash flow (DCF) analysis, net present value (NPV) analysis, and internal rate of return (IRR) analysis. In these analyses, the hurdle rate is used as the discount rate or the required rate of return, and the investment's expected returns are compared to the hurdle rate to determine its viability. If the expected returns are higher than the hurdle rate, the investment is considered worthwhile. If the expected returns are lower than the hurdle rate, the investment is considered less attractive.

The hurdle rate is one of the key factors used in Financial Analysis Templates to calculate NPV and IRR.

Here's a more detailed explanation of the discount rate in DCF analysis:

1) Time Value of Money (TVM): The core principle behind the discount rate is the time value of money. It recognizes that a dollar received in the future is worth less than a dollar received today. This is because you can invest money today and earn a return on it, which will make it worth more in the future.

2) Risk and Opportunity Cost:The discount rate incorporates two important factors:

• Risk: It reflects the risk associated with the investment. Riskier investments generally require a higher discount rate because investors will demand a higher return to compensate for taking on more risk.
• Opportunity Cost: It represents the return an investor could earn from a similar investment with a similar level of risk. If an investment doesn't offer returns greater than the opportunity cost, it may not be considered a worthwhile investment.

3) Components of the Discount Rate:

• Risk-Free Rate: This is the theoretical return on an investment with zero risk. Typically, it's based on the yield of government bonds, such as the yield on the U.S. Treasury bond with a maturity matching the investment horizon.
• Risk Premium: The risk premium is added to the risk-free rate to account for the specific risk associated with the investment. This premium is often based on factors like the business's industry, financial stability, and other market conditions.
• Size Premium: For smaller companies or projects, an additional premium may be added to account for the added risk associated with their size and potential lack of diversification.