Also known as the minimum acceptable rate of return or MARR, the hurdle rate is a term used to describe the least amount of return that can be generated by a given strategy or project and still be considered acceptable by those initiating the project. The general idea is to ensure that any actions taken will overcome the hurdle of failure and be able to make the leap into a profitable state that is considered worthy of the use of time and other resources required to fully complete the project. Unless there is a good chance of reaching this hurdle rate, the strategy is often abandoned and other courses of action are considered.
The concept of a hurdle rate is often employed with both financial speculation and business operations. With business, the goal is to make sure that a particular investment will provide an acceptable amount of return or profit, considering the resources that must be utilized to bring the project to fruition. For example, an business that is considering the acquisition of another company will look closely at the chances of the deal turning a profit within a given amount of time, effectively offsetting the costs associated with the acquisition and eventually strengthening the overall position of the business. If the rate of return is considered too small, or will take so long that it is likely to have a negative impact on the business functions of the acquiring business, there is a good chance that the project will never be undertaken.
In like manner, an investor will want to pursue stocks, bonds, and other forms of investing that are likely to generate an attractive rate of return. This means that the investor will look closely at the past performance, current status, and future prospects of the investment before making a purchase. Assuming that the hurdle rate is within an acceptable range, the investor can proceed with relative confidence of at least earning that minimum return, and thus being happy with the outcome of his or her investing efforts.
It is important to note that a hurdle rate is only the minimum amount of return that is deemed acceptable for the efforts involved. The consideration of the risk premium and other relevant factors does not necessarily provide a picture of the full potential of the project, only that it will be profitable enough to meet minimum expectations. Once the hurdle rate is achieved during an active project, it is often possible to begin projecting additional levels of return. If the project is not likely to produce more than the hurdle rate, the business can then determine if it is worth the investment of additional resources to increase profitability, or phase out the project in favor of something that shows greater promise.
