ExecuSpeak Dictionary: Hurdle Rate
NEW YORK (ExecuSpeak Dictionary) -- Is it a good deal? The fast answer is this: If it exceeds the hurdle rate. But there's more to it than just a number.
The hurdle rate is the measure used to determine if an investment is considered to be worth spending the money. It's used to compare and contrast a multitude of investment and project choices.
Most explanations indicate that the calculation is designed to make the decision (this investment vs. that investment vs. no investment) a quantitative and financial decision. Presumably, the hurdle rate considers risk. Thus projects to reduce costs are likely to have a lower hurdle than projects associated with new products since new products are more risky.
It is essential to understand that the hurdle rate varies. The decision makers have determined, in advance, which measure will be considered their "hurdle rate." The preferred measure to define the hurdle rate at one company may be return on investment (ROI). Another company prefers internal rate of return (IRR). Others might select net present value (NPV). Sometimes the hurdle rate is referred to as the "required rate of return." That's the first part.
The second element of the hurdle rate information is the actual number or the metric. There are lots of ways to select, or justify, the actual value once NPV or ROI or IRR is selected. The choice of interest rates (whether the formula uses 2% or 3% or 3.5%) selected for the cost of capital and the alternative investment (U.S. Treasuries or money market) are decisions. But even then the actual metric will vary since one venture capital (VC) firm may set their hurdle rate at an ROI of 30% on a project in cleantech while another venture capital firm may set the bar at 35%. Or a large corporation might use NPV to compare and contrast investments across divisions and subsidiaries.
The choices made in selecting the composition of the formula -- the interest rate selected, the measurement selected (NPV or ROI or IRR), the way the calculation is used and discussed -- all provide insight into the investing group's priorities and values.
Beyond this technical discussion of the metric, the number and the calculation, the hurdle rate is not about the number. It's a filter. It's a means of separating the wheat from the chaff to organize a potentially overwhelming set of investment choices and options. It's a management tool to organize a broad array of investment options.