Hurdle Rate (MARR) And Internal Rate of Return(IRR)Definition
What is a Hurdle Rate (MARR) ?
A hurdle rate, which is also known as the minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors that could directly affect an investment.
Before accepting and implementing a certain investment project, its internal rate of return (IRR) should be equal to or greater than the hurdle rate. Any potential investments must possess a return rate that is higher than the hurdle rate in order for it to be acceptable in the long run.
What is the Internal Rate of Return (IRR)?
The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment. In the example below, an initial investment of $50 has a 22% IRR. That is equal to earning a 22% compound annual growth rate.
When calculating IRR, expected cash flows for a project or investment are given and the NPV equals zero. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flows of that investment. (Cost paid = present value of future cash flows, and hence, the net present value = 0).
Once the internal rate of return is determined, it is typically compared to a company's hurdle rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. (That is, of course, assuming this is the sole basis for the decision.
In reality, there are many other quantitative and qualitative factors that are considered in an investment decision.) If the IRR is lower than the hurdle rate, then it would be rejected.
Hurdle Rate vs. Internal Rate of Return (IRR): What's the Difference?
When a company decides whether a project is worth the costs that will be incurred in undertaking it, it may evaluate it by comparing the internal rate of return (IRR) on the project to the hurdle rate, or the minimum acceptable rate of return (MARR).
Under this approach, if the IRR is equal to or greater than the hurdle rate, the project is likely to be approved. If it is not, the project is rejected.
The hurdle rate, also called the minimum acceptable rate of return, is the lowest rate of return that the project must earn in order to offset the costs of the investment.
Projects are also evaluated by discounting future cash flows to the present by the hurdle rate in order to calculate the net present value (NPV), which represents the difference between the present value of cash inflows and the present value of cash outflows.
Generally, the hurdle rate is equal to the company's costs of capital, which is a combination of the cost of equity and the cost of debt. Managers typically raise the hurdle rate for riskier projects or when the company is comparing multiple investment opportunities.
Internal Rate of Return (IRR)
The internal rate of return is the expected annual amount of money, expressed as a percentage, that the investment can be expected to produce for the company over and above the hurdle rate.
The word “internal” means that the figure does not account for potential external risks and factors such as inflation.
IRR is also used by financial professionals to compute the expected returns on stocks or other investments, such as the yield to maturity on bonds.
The rate of return excludes potential external factors, and is therefore an “internal” rate.
While it is relatively straightforward to evaluate projects by comparing the IRR to the hurdle rate, or MARR, this approach has certain limitations as an investing strategy. For example, it looks only at the rate of return, as opposed to the size of the return. A $2 investment returning $20 has a much higher rate of return than a $2 million investment returning $4 million.
IRR can only be used when looking at projects and investments that have an initial cash outflow followed by one or more inflows. Also, this method does not consider the possibility that various projects might have different durations.
What IRR Really Means (Another Example)
Let's look at an example of a financial model in Excel to see what the internal rate of return number really means.
If an investor paid $463,846 (which is the negative cash flow shown in cell C178) for a series of positive cash flows as shown in cells D178 to J178, the IRR they would receive is 10%. This means the net present value of all these cash flows (including the negative outflow) is zero and that only the 10% rate of return is earned.
If the investors paid less than $463,846 for all same additional cash flows, then their IRR would be higher than 10%. Conversely, if they paid more than $463,846, then their IRR would be lower than 10%.
How Important is the Hurdle Rate in Capital Investments?
The hurdle rate is often set to the weighted average cost of capital (WACC), also known as the benchmark or cut-off rate. Generally, it is utilized to analyze a potential investment, taking the risks involved and the opportunity cost of foregoing other projects into consideration. One of the main advantages of a hurdle rate is its objectivity, which prevents management from accepting a project based on non-financial factors. Some projects get more attention due to popularity, while others involve the use of new and exciting technology.
What are the Limitations of Using a Hurdle Rate?
It's not always as straightforward as picking the investment with the highest internal rate of return. A few important points to note are:
- Hurdle rates can favor investments with high rates of return, even if the dollar amount (NPV) is very small.
- They may reject huge dollar value projects that may generate more cash for the investors but at a lower rate of return.
- The cost of capital is usually the basis of a hurdle rate and it may change over time.