In many organizations, those submitting proposals must show that returns will clear a "hurdle rate" in order to be considered for funding.
An organization's hurdle rate is defined as the minimum rate of return it will consider, when evaluating investment and action proposals.
- Proposals that score above the hurdle rate may receive further consideration.
- Proposals scoring below the hurdle rate receive no further consideration.
In other words, when its rate of return clears the hurdle, the proposal qualifies for funding consideration.
The Hurdle Rate Role in Proposal Review
Action proposals almost always contain projected financial results. And, they almost always present these as a cash flow stream. Hence, almost all action proposals project a series of cash flow events that follow the investment or action.
Reviewers evaluate proposals with the help of financial metrics for analyzing cash flows. They are concerned with proposal acceptance and funding, after all, and they turn to metrics that take an "investment view." Consequently, they will probably analyze with net present value, return on investment, payback, and internal rate of return. In brief, all of these are relevant in a thorough review. In addition, a thorough review also finds and measures investment risks. And, finally, a thorough review also addresses this question: "Do projected outcomes align with strategic objectives?"
The hurdle rate serves in this context as an initial screening test. The hurdle rate test, therefore, normally precedes the full proposal review. The idea is to filter out, or disqualify, weak proposals, early. Reviewers, therefore, have more time and resources to focus on the stronger proposals.
Explaining Hurdle rate in Context
Following sections further explain the use of direct and indirect labor classifications. This appears in the context of related terms and concepts including the following:
- What is a Hurdle Rate?
- Applying the hurdle rate test.
- Finding the elusive Rate of Return.
- Using internal rate of return as Hurdle Rate.
- Where are Hurdle Rate tests used?
- For more on internal rate of return IRR and modified internal rate of return MIRR, see the article Internal Rate of Return.
- See the article Financial Metrics for an introduction to all important cash flow metrics and financial statement metrics (Business ratios)..
- For more on the role of business case analysis in financial justification, see the article Business Case.
The hurdle rate test requires two numbers.
- First, the test requires the arbitrarily chosen hurdle rate, itself.
- Secondly, the test needs the "rate of return" promised by the proposal.
Note also that the test has only two possible outcomes:
- Proposal rate of return clears the hurdle.
- Proposal rate of return does not clear the hurdle.
Choosing the hurdle rate
Financial officers are free to set the hurdle rate as any figure they wish. Usually, they use the organization's weighted average cost of capital (WACC). In principle, they could just as well use other company metrics. Some in fact do use metrics such as return on capital employed, return on assets, or return on equity. Most choose WACC as the hurdle rate, however. This is probably because these same officers also find an internal rate of return (IRR) for the proposal. The hurdle test, then, compares proposal IRR to the WACC hurdle rate.
Incidentally, using IRR and WACC together this way is common practice in finance. In brief, when investment IRR is greater than WACC, those with financial training normally see the investment as a net gain. And, when IRR is less than WACC, they view it as a net loss.
Note once more that financial officers are free to set the hurdle rate as they wish. This is because the hurdle rate serves internal decision making, only. And, It plays no role in financial accounting or reporting. Consequently, hurdle rate practice need not conform to GAAP or to government reporting rules. Therefore, financial officers can apply subjective judgments, draw upon their experience, and adjust hurdle rate to something other than WACC. They may lift the hurdle rate several percentage points, for instance, when they believe a proposal is risky.
Note also that the hurdle rate has several other names. It may be called minimum acceptable rate of return (MARR), or required rate of return, or simply, target rate.
Textbooks use the term "rate of return" to explain hurdle rate. Here, they have in mind a financial metric based on financial results in the proposal. This is the rate the analyst will compare to the existing hurdle rate. One problem, however, is that "rate of return," does not have a standard definition. And, the term does not designate any metric in particular. For the hurdle rate test, therefore, financial specialists usually turn to one metric that does have a standard definition. The metric of choice for this purpose is the internal rate of return (IRR).
IRR has several mathematical definitions but the best known is this:
The internal rate of return is the interest rate for which the net present value of all proposal cash flows equals 0.
This definition, by the way, is not a formula for calculating IRR. More accurately, it is a guide for finding IRR.
- One approach is to approximate IRR with a graphical solution. Here, cash flow NPV is plotted as a function of discounting interest rate. IRR then stands out as the rate with NPV = 0.
- More often, however, business people use spreadsheets to find IRR. in Microsoft Excel, therefore, a cell showing an IRR result holds a formula like this: =IRR(B2:B:11,0.1)
- B2:B11 is a spreadsheet range of 10 cells. Each holds a net cash flow figure. And, together, these are the proposal cash flow stream.
- 0.1 is an initial guess for the IRR. This guess serves simply as a starting point for approximation trials. Trials continue until it finds a rate that produces NPV=0. This occurs very quickly. For the spreadsheet user, IRR results seem to appear instantly.
See the online article internal rate of returnfor more on finding and using IRR.
Note, finally, that not everyone uses the proposal IRR for the hurdle rate test. Some define "rate of return" using other metrics they are more comfortable with. Some may use simple return on investment (ROI), while others use average rate of return. Still others choose another metric.
The hurdle rate concept is best known for it's role in capital budgeting. However, the concept is used in other business processes, as well. In fact, the hurdle rate can turn up anywhere that managers receive, evaluate, and prioritize proposals. As a result, the hurdle rate test can appear in all of these areas:
Capital Budgeting and Capital Review
Capital budgeting normally begins with a capital review at the start of a capital budget cycle. For this, a Capital Review Committee solicits spending proposals, organization wide, for capital acquisitions and capital projects. And, they also set a limit for total capital spending (a capital spending ceiling). Usually, the funding request total exceeds the capital spending ceiling. Incoming proposals, therefore, must compete for available funds, and not all will be funded. As a result, the Review Committee's primary task is to evaluate and prioritize all incoming proposals. For each proposal, evaluation begins with the hurdle rate test.
Project Management Office
PMOs in some organizations receive a large number of project proposals. The result is a very heavy evaluation workload for a few PMO officers. Consequently, many apply the hurdle rate test to each income proposal, first. Proposals that clear the hurdle move on to a thorough review and further consideration. The rest are non-starters.
Product Management Office
Proposals for new products can reach high volume. Companies normally expect to bring only a small percentage of these to market. The in-depth review of product proposals will examine many factosr. These will include marketing and sales considerations, of course, as well as the company's overall product strategy. Before reaching the in-depth review, however, proposal sponsors may have to submit to the hurdle test.
Information Technology Directors
IT departments usually support units across the entire organization. As a result, IT directors often receive a very large number of proposals. These may include, for example, proposals for new devices, new applications, new IT capabilities, or various IT projects.
Most IT units, however, do not have the time and resources for meeting all incoming requests. Consequently, IT directors spend much of their own time evaluating and prioritizing IT support requests. Therefore, many IT directors now require business case support with incoming proposals. And, they may choose to evaluate fully only those proposals that pass the hurdle rate test.
Continuous Improvement & Innovation Groups
Continuous Improvement / Innovation Groups. Some organizations create groups chartered specifically to facilitate "continuous improvement" or "innovation." These groups also receive action proposals from across the organization. And, such proposals typically vary substantially, in nature, size, and scope.
Group members will then evaluate incoming proposals in terms of feasibility, risks, and added value to the organization. As a result, this calls for substantial time and resources from group members. However, they can use the hurdle rate test to disqualify weak proposals early.