When you’re thinking about investing in a new project, you need to know if you can get your investment back and earn a profit. After all, a project that doesn’t end up paying for itself is a negative in more ways than one. A useful tool for making decisions about financing is knowing the hurdle rate, or minimum acceptable rate of return, of your project.
What is a Hurdle Rate?
A hurdle rate is a percentage or a dollar amount a project must return to cover investment financing costs and show an acceptable level of profit. You can perform a discounted cash flow (DCF) analysis to use the hurdle rate in evaluating an investment. With a DCF analysis, you use the concept of the time value of money to forecast your future cash flows. Then, you discount the amounts back to today’s value at the hurdle rate, which gives you the net present value (NPV).
Evaluating an Investment Using the Hurdle Rate
If you’re in the business of renovating and rehabilitating apartment buildings, you might take out a loan at 15% interest to finance a new rehab project of a 16-unit building.
Your discount rate for the project’s future cash flows equals the project’s investment, which means it has a zero NPV. The discount rate you need is the hurdle rate, which tells you how profitable your project might be. Using the 15% financing rate as your hurdle rate, your new project breaks even. If your hurdle rate is higher than 15%, your project makes money, but if it’s lower than 15%, the project loses money.
Hurdle Rate and Measuring Rates of Return
Whether you’re doing project evaluation or capital budgeting, you can consider the hurdle rate as a way of measuring your return on investment (ROI). The difference between your project’s hurdle rate and financing cost becomes your project’s ROI. Another way of looking at the hurdle rate is that it’s your business’ internal rate of return (IRR).
This point of view helps when you’re comparing the costs of various financing rates. You might think of the IRR as the maximum rate of financing your project can afford and not lose money. The IRR should be equal to or greater than the hurdle rate to ensure profitability.
Balancing Payback Periods and Hurdle Rates
When you’re concerned about cost recovery in your projects, it’s a good idea to look at your payback period as more significant than your hurdle rate. The payback period is the length of time it takes for a project to generate a sum of cash flows equal to the total cost of the investment. Perhaps you invested $15,000 in purchasing a six-Social Insurance gas bakery convection oven for your bake shop and cafe, and another $5,000 in furniture and furnishings for the cafe dining area.
If it takes you 26 months before your total cash flows from walk-in customers, online orders, local restaurant contracts, and catering dates equal $20,000, your payback period is 26 months. You might find this approach to cost recovery useful if your business runs multiple projects at the same time. Choosing projects with the shortest payback periods enables you to recover your investment cost more quickly, even if you don’t have the ideal hurdle rate.
One big hurdle for small businesses is ensuring optimum cash flow, which is essential for your enterprise to thrive. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.