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Hello tutor,
Could you kindly tell me what is the difference between hurdle rate and cost of capital?
Thank you.
The hurdle rate is a rate of return, usually somewhat arbitrary) set by management as being the minimum acceptable return needed before a project is accepted. It is usually used in the context of a measure like the accounting rate of return/return on capital employed. These are non-DCF methods of project appraisal so IRR is not usually calculated as well.
Eg, the accounting rate of return (AAR) = Average annual earnings after depreciation/Average capital invested.
The method is simple to apply (though DCF provides better approaches), does not require a cost of capital to be known and gives quick accept reject decisions.
The cost of capital is the average cost of providing capital (usually a mix of equity and debt capital). It is needed for DCF project DCF calculations.
Logically the hurdle rate should be linked to the cost of capital. However, if the CC is known, why not go the whole way and use DCF rather than the inferior ARR/ROCE?
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