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.
Hurdle Rate
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.
Key Takeaways
- The hurdle rate is the minimum rate of return on an investment that will offset its costs.
- The internal rate of return is the amount above the break-even point that an investment may earn.
- A favorable decision on a project can be expected only if the internal rate of return is equal to or above the hurdle rate.
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.
Important
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.
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