What Does Threshold Rate of Return Mean?
The threshold rate of return is the minimum return that an investor can expect to achieve when investing in a project. It is influenced by the risk of the investment, the liquidity of the investment, and inflation. This is the benchmark or threshold, potential projects with a rate below the threshold rate of return are discarded.
The threshold rate of return is often referred to as the hurdle rate or the minimum rate of return.
Divestopedia Explains Threshold Rate of Return
The threshold rate of return is an excellent tool for sorting through a variety of investment options that are subject to management strategies. This rate can never be lower than the cost of capital. A higher rate is expected from a risky investment.
For a liquid investment, the required rate of return is lower. High expected inflation drastically increases the required rate of return. An investor has the choice of committing investable resources that can be held as reserves or invested in a project.
The threshold rate of return for a project is the no-risk opportunity cost of these resources. A perceived higher level of risk and the probability that an investment may fail to produce any return is compensated for by raising the threshold rate of return. This is the investment risk premium.
For investment in disadvantaged economies and emerging markets, a higher threshold rate of return is expected. The investor takes a calculated risk, such that the positive factors outweigh the negative to make the odds worthwhile. In mergers and acquisitions, the threshold rate of return must be greater than the cost of capital; how much higher depends upon the acquiring firm's management goals. It should be at least as high as is used to approve internal expansion projects. This rate is used in evaluating acquisition candidates based on the cost of capital. The capitalization rate is adjusted for company-specific and industry-specific circumstances and risk factors. To reflect fact-specific, time-related business and industry risk, the capitalization rate is adjusted to arrive at the threshold rate of return.
Strategic and financial buyers use rate of return as one of the primary measures to assess the attractiveness of an investment. Sophisticated buyers look for a minimum thresehold rate of return of 25% for their investment in mid-market companies due to the risk and more limited liquidity options available.
Hurdle Rate, Minimum Rate of Return