Does your project exceed the interest rate hurdle?
The term hurdle rate gives you the mental picture of getting past some barrier before your project can be justified. This is exactly the case when you are analyzing a project using net present value (NPV-Calculator). You must set an interest rate to discount your cash flows by.
This rate could also be used with IRR calculations(Calculating Internal Rate Of Return). You would only accept projects with an IRR greater than this minimum interest rate.
There are several factors that should be considered when choosing a discount rate. Some of these factors are:
|The Bank Interest Rate||What return can you get for your money (or interest you are paying for your money)|
|The Required Risk Premium||A risky project may require a substantial risk premium|
|The Inflation Rate||If inflation is mild then this factor may influence the final rate by only 1%-2%. However there are times when the inflation factor may be the most significant factor.|
Care should be used not to set to high a cutoff rate. A high rate could act as an obstacle to otherwise profitable projects. It could also have the effect of favoring short term projects over long term projects.
The following is an example of how a company might construct a cutoff rate for analyzing their internal projects:
|The cost of money from a bank line of credit||8%|
|Risk premium - low risk project||1%|
|Inflation expectation during the life of the project 4%-6%||5%|
|Target Rate / Cutoff Rate||14%|
The hurdle rate accounts for the cost of the money, risk and inflation. It is the barrier that your project must overcome in order to be economically justifiable.