The hurdle rate is the discounting rate at which all of a company’s investments must exhibit a positive cash flow. It is called a hurdle rate because the summary of all cash flows must exceed, or hurdle, this rate, or else the underlying investments will not be approved. The use of a discount rate is extremely important, for it reduces the value of cash inflows and outflows scheduled for some time in the future, so that they are comparable to the value of cash flows in the present. Without the use of a discount rate, we would judge the value of a cash flow ten years in the future to be the same as one that occurs right now. However, the difference between the two is that the funds received now can also earn interest for the next ten years, whereas there is no such opportunity to invest the funds that will arrive in ten years. Consequently, a discount rate is the great equalizer that allows us to make one-to-one comparisons between cash flows in different periods.
The hurdle rate is derived from the cost of capital. This is the average cost of funds that a company uses, and is based on the average cost of its debt, equity, and various other funding sources that are combinations of these two basic forms of funds. For example, if a company has determined its cost of capital to be 16%, then the discounted cash flows from all of its new capital investments, using that discount rate, must yield a positive return. If they do not, then the funds flow resulting from its capital investments will not be sufficient for the company to pay for the funds it invested. Thus, the primary basis upon which to review potential capital investments is the hurdle rate.
A company may choose to use several hurdle rates, depending on the nature of the investment. For example, if the company must install equipment to make its production emissions compliant with federal air quality standards, then there is no hurdle rate at all – the company must complete the work, or be fined by the government. At the opposite extreme, a company may assign a high hurdle rate to all projects that are considered unusually risky. For example, if capital projects are for the extension of a current production line, there is very little perceived risk, and a hurdle rate that matches the cost of capital is deemed sufficient. However, if the capital expenditure is for a production line that creates equipment in a new market, where the company is the first entrant, and no one knows what kind of sales will result, the hurdle rate may be set a number of percentage points higher than the cost of capital. Thus, different hurdle rates can apply to different situations.