Discount Rate, Hurdle Rate, Actual Rate of Return

There are three terms to understand for decision-making that sound similar: discount rate, hurdle rate, and actual rate of return.

The discount rate is any rate that you use to calculate the time value of money. For example, when calculating the net present value method of decision-making, we use the hurdle rate as the discount rate.

Then what is the hurdle rate? The hurdle rate is the minimum rate of return that you want to receive on an investment. The word hurdle, quite literally, is an obstacle that an athlete jumps over. In the same way, management chooses investments that get a rate of return that is over the hurdle rate.

For example, let’s say that your business has the option of investing in a new office building and management sets a hurdle rate of 5%. That means that, as long as the actual rate of return is above 5%, management will accept this decision to invest in the office building.

Then there’s the actual rate of return. This isn’t referring to the rate that we wanted (i.e., the hurdle rate). This is the actual rate of return that we get on an investment.