the minimum rate of return on a project .

a manager or company is willing to

accept before starting a project, given

its risk and the opportunity cost of

forgoing other projects.

investment required by a manager or

investor. In order to compensate for risk,

the riskier the project, the higher the

hurdle rate.

Also Known as hurdle rate.

The required return in capital budgeting.

The minimum return necessary for a fund

manager to start collecting incentive

fees.

The hurdle is usually tied to a benchmark

rate such as Libor or the one-year

Treasury bill rate plus a spread.

Within a firm, there may be different

minimum acceptable rates of return

The minimum acceptable rate of return must

cover the cost of capital for the alternatives being considered

If a firm has a mixture of debt and equity:

Weighted average cost of capital establishes a floor for the minimum acceptable rate of return

Minimum acceptable rate of return is usually

between:

Weighted average cost of capital

Cost of equity capital

There is NO universally accepted method for

setting the minimum acceptable rate of return

(No single method used by all companies)

1. Project risks

2. Investment opportunities

3. Limits on available capital

4. Rate of return at other companies

5. Tax structure

Where there is greater risk:

Set higher minimum acceptable rate of return!

Risk-adjusted minimum acceptable rate of return

Higher cost of debt for risky projects:

Want extra return on average

In case the project does not produce its

projected revenues

If management wants to expand:

Set lower minimum acceptable rate of

return!

Encourage investment in desired areas

As debt and equity capital become limited:

Minimum acceptable rate of return increases! Demand for capital exceeds supply:

(Basic supply and demand at work!)

Opportunity cost plays a role in setting the

minimum acceptable rate of return

Consider two companies:

One with obsolete equipment One with brand-new equipment

Which company should have a higher

minimum acceptable rate of return?

If competitors increase their minimum acceptable rates of return:

A company may choose to follow suit

And vice versa!

These variations are often based on:

Changes in interest rates for loans (which directly affect the cost of capital)

Federal Reserve monetary policy (changing interest rates charged to member banks)

Companies with low minimum acceptable rates of return will tend to invest more in competitiveness!

Rising corporate taxes:

Due to increased profits, capital gains,

changes in local tax rates, etc.)

create pressure to increase the minimum

acceptable rate of return

Not true for after-tax analysis:

Apply minimum acceptable rate of

return to after-tax costs, revenues

Determine the MARR of the company

that can borrow funds 8.5% and requires

7% profit margin of return.

So we can simply conclude that

MARR= 8.5% + 7% =15.5%

An NPV result greater than zero means that you will exceed the required rate-of-return (you will exceed the "hurdle rate"), which means the investment is acceptable.

Example: A seed investor is considering investing in a startup company. Given the current market conditions, the seed investor chooses to use a hurdle rate between 50% to 100% to compensate for risk. The seed investor considers 2M shares for investing $2M in the startup after determining that the 2M shares will have a potential market value of $37.5/share (less tax) in 5 years. To determine if the seed investor will accept or reject this offering, enter the following numbers below into the calculator above:

Hurdle rate: 0.5

Initial Investment: -2000000 ($2M

investment, enter as negative number)

Year End 1 through Year End 4 cash flows

= 0 (no shares sold until year 5)

Year End 5 cash flow 60000000 (2M

shares x ($37.5/share - $7.5/share tax))

Result at 0.5 hurdle rate = 5901234

(Accept)

Hurdle rate: 1.0

Initial Investment: -2000000 ($2M

investment, enter as negative number)

Year End 1 through Year End 4 cash flows

= 0 (no shares sold until year 5)

Year End 5 cash flow 60000000 (2M

shares x ($37.5/share - $7.5/share tax))

Result at 1.0 hurdle rate = -125000

(Reject)

In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.

The minimum acceptable rate of return depends on:

Cost of capital

Mix between debt and equity financing

Minimum acceptable rate of return should be at least as large as the weighted average cost of capital:

With an allowance for risk

And consideration of opportunity costs!