The first rule of making money is to get more out than you put in. In business, a project must generate a higher return than it costs. Rather than thinking about how much an ice cream machine costs when deciding whether to start an ice cream business, companies think in terms of how much the money to buy the machine is going to cost. This cost of capital can be broken down into the risk-free rate (the minimum return on an investment that seemingly carries no risk) and the corporate risk premium (to compensate for business risk). Any project that can earn more than the cost of capital is golden – it returns an economic profit and is therefore viable.

However, another layer of return is often required on top of the cost of capital. This additional margin, which is set by the company, acts as a buffer or a safety net in case the project yields less profit than expected. Together, these three elements make up a company’s hurdle rate – the magic number a project’s prospective return on capital must hit in order to be considered by management (Figure 1).