Hurdle Rate

A company has limited money and many possible uses for it. The hurdle rate sets the bar a project must clear to be worth doing. If a project's expected return is below the hurdle rate, it is rejected.

The hurdle rate is usually based on the company's cost of capital, since a project that earns less than the cost of its funding would destroy value. Many companies add an extra margin for risk. A safe project, such as replacing old equipment, might have a hurdle rate close to the cost of capital, while a risky venture into a new market might need to clear a much higher rate.

For example, a company with a cost of capital of 8% might set a hurdle rate of 10% for normal projects and 15% for high-risk ones. A project with an expected internal rate of return of 12% would be approved under the first rate but rejected under the second.

Setting the hurdle rate too low risks approving poor investments, while setting it too high can cause a company to pass up good opportunities.