Definition: Hurdle rate is a managerial accounting term used to describe the lowest rate of return that is acceptable for an investment. In other words, a hurdle rate is minimum return or amount of money a company expects to receive from an investment.
What Does Hurdle Rate Mean?
Most company managers use some type of internal rate of return calculation to analyze company investments. These investments can either be internal projects, like building a piece of manufacturing machinery, or actual capital investments, like buying new machinery.
Managers have to consider the cost of the investment as well as the return. Managers use the hurdle rate as a decision making tool when considering new investments.
Example
Expanding a manufacturing plant building is a good example for a typical investment. In order to build a new building, the company has to take out a loan at 5%. This means that the company has to earn at least a 5% return on its new building in order to break even on this investment. The hurdle rate in this example is 5%.
The business has to get over the hurdle rate in order to actually make a profit on its investments. If the company’s internal rate of return was only 3%, it wouldn’t meet the hurdle rate and the expansion shouldn’t be approved. On the other hand, if the company can achieve an internal rate of return of 7%, it should go ahead and build the new building.
The hurdle rate is often compared to the internal rate of return for this very reason. Managers can easily tell whether or not to accept a new investment. If the internal rate of return is larger than the hurdle rate, the investment should be accepted. If it isn’t, the investment should be denied.
