Is a new project or investment worth it? [A hurdle rate, or ]the lowest rate of return you can accept on a project or investment, is a calculated benchmark technique used to determine whether you should accept or if the risk isn’t worth the return. If the return on a project is expected to exceed your hurdle rate, you accept the job. If it doesn’t exceed your hurdle rate, you should consider turning it down.
Your hurdle rate is determined based on prior projects and expectations of future work. If your current profit margin on projects is 10%, and this rate is expected in the future, your hurdle rate could be set at 10%. When a client approaches you with an opportunity that will yield an 8% return, you may want to consider turning away the job in case you receive opportunities that exceed your hurdle rate. Your company’s hurdle rate may be the same as your internal rate of return.
The main downside to using a hurdle rate when evaluating opportunities is its lack of recognizing your capacity. If your firm has extra staff that’s looking for projects, it may make sense to take on opportunities below your hurdle rate. Say a client approaches you about a project that produces a 5% profit. If you have excess capacity and don’t anticipate needing the extra time in the future, you probably want to accept the job because it’s profitable even if your hurdle rate is 8%.
Inflation, competition, and general risk all impact your hurdle rate. Higher inflation means the dollar has less purchasing power, so your hurdle rate should be higher. Higher competition within an industry also means your profit margins are lower and hurdle rate is low. The risk you incur is offset by higher interest rates. Riskier endeavors should offset a higher hurdle rate. Make sure to watch how you calculate your hurdle rate, as it is a major factor in determining whether you should take on a client, project, or investment.