Overview of the Hurdle Rate
The hurdle rate is the discount rate for which the cash flows of a proposed capital purchase must generate zero or positive discounted cash flows. The cash flows from a proposed project must at least equal zero when discounted using this rate, or else a company as a whole will generate a negative rate of return from the funds that it uses.
The hurdle rate is based on a company's cost of capital. The cost of capital is the blended cost to the business of obtaining funding from debt and equity. Thus, if the cost of capital is currently 12%, this is used as the hurdle rate.
Using Multiple Hurdle Rates
It is possible that more than one hurdle rate will be used in the fixed asset proposal review process. Consider the following alternatives:
- Legal requirement. If a company is required by law to make an investment (such as for smokestack scrubbers), the hurdle rate does not apply at all, and cash flow discounting is irrelevant to the investment decision. The company must make the investment, no matter what the return from the investment may be.
- Risky outcome. If a proposed investment is considered to have an unusually risky outcome, the hurdle rate could be increased to reflect the higher degree of risk. This means that a risky project will only be accepted if it generates unusually high cash flows. An example of a risky investment is when the company is about to enter an entirely new market with which it is not familiar, and wants to invest funds in the construction of a production line for this market.