In business and for
engineering economics in both
industrial engineering
Industrial engineering is an engineering profession that is concerned with the optimization of complex processes, systems, or organizations by developing, improving and implementing integrated systems of people, money, knowledge, information an ...
and
civil engineering practice, the minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is 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.
A synonym seen in many contexts is minimum attractive rate of return.
The hurdle rate is frequently used as a synonym of cutoff rate,
benchmark and
cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...
. It is used to conduct preliminary analysis of proposed projects and generally increases with increased risk.
Hurdle rate determination
The hurdle rate is usually determined by evaluating existing opportunities in operations expansion, rate of return for investments, and other factors deemed relevant by management. As an example, suppose a manager knows that investing in a conservative project, such as a bond investment or another project with no risk, yields a known rate of return. When analyzing a new project, the manager may use the conservative project's rate of return as the MARR. The manager will only implement the new project if its anticipated return exceeds the MARR by at least the
risk premium of the new project.
A risk premium can also be attached to the hurdle rate if management feels that specific opportunities inherently contain more risk than others that could be pursued with the same resources. A common method for evaluating a hurdle rate is to apply the
discounted cash flow method to the project, which is used in
net present value models. The hurdle rate determines how rapidly the value of the dollar decreases out in time, which, parenthetically, is a significant factor in determining the payback period for the capital project when discounting forecast savings and spending back to present-day terms. Most companies use a 12% hurdle rate, which is based on the fact that the
S&P 500
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of ...
typically yields returns somewhere between 8% and 11% (annualized). Companies operating in industries with more volatile markets might use a slightly higher rate in order to offset risk and attract investors.
The hurdle rate is frequently used as a synonym of cutoff rate,
benchmark and
cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...
. Different organizations might have slightly different interpretations, so when multiple organizations (e.g., a
startup company
A startup or start-up is a company or project undertaken by an entrepreneur to seek, develop, and validate a scalable business model. While entrepreneurship refers to all new businesses, including self-employment and businesses that never intend t ...
and a
venture capital firm
Venture capital (often abbreviated as VC) is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which hav ...
) are discussing the suitability of investing in a project, it is important that both sides' understanding of the term are compatible for this purpose.
The hurdle rate is always higher (usually significantly) than the cost of capital - since generally no project is undertaken by a for profit entity that does not have an expected rate of return higher than the cost of capital (i.e., a profit) and every project has risk ( which must be compensated for).
Project analysis
When a project has been proposed, it must first go through a preliminary analysis in order to determine whether or not it has a positive
net present value using the MARR as the discount rate.
[ The MARR is the target rate for evaluation of the project investment. This is accomplished by creating a cash flow diagram for the project, and moving all of the transactions on that diagram to the same point, using the MARR as the interest rate. If the resulting value at that point is zero or higher, then the project will move on to the next stage of analysis. Otherwise, it is discarded. The MARR generally increases with increased risk.
]
Typical values
The MARR is often decomposed into the sum of the following components (range of typical values shown):
Notes
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See also
*Weighted average cost of capital
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by ...
*Cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...
* Internal rate of return
Financial markets
Corporate finance