7 junio, 2024

MARR (minimum acceptable rate of return): what it is, calculation, examples

What is the MARR?

The MARR (minimum acceptable rate of return) It is the return that an investor reasonably expects to earn from an investment, taking into account the risks of the investment and the opportunity cost of executing it, rather than other investments.

Indicates the minimum rate of return that a project manager considers acceptable for starting a project. Managers apply this concept to a wide variety of projects to determine whether the benefits or risks of one project exceed those of other possible ones.

The MARR is generally determined by evaluating existing opportunities for expansion of operations, the rate of return on investments, and other factors that management considers relevant.

investment evaluation

Business managers are constantly considering investments in new products and capital expenditures. However, they should have a measure that helps them determine whether these new projects represent a worthwhile use of company funds.

The MARR is the objective rate in evaluating the investment in the project. This is accomplished by creating a cash flow chart for the project and moving all the transactions on that chart to the same point in time, using the MARR as the interest rate.

If the resulting value at that set point is zero or higher, the project will move on to the next stage of analysis. Otherwise, it is discarded. The MARR will generally increase if there is greater risk to be faced.

What is the minimum acceptable rate of return?

In business and engineering economics, the MARR is the minimum rate of return from a project that a company is willing to accept before starting the project, given its risk and the opportunity cost of forgoing other projects.

The general formula for the MARR is: MARR = project value + loan interest rate + expected inflation rate + changes in the inflation rate + loan default risk + project risk.

For most companies, the MARR is the company’s weighted average cost of capital (WACC). This number is determined by the amount of debt and equity on the balance sheet. It is different for every business.

Project analysis

Managers evaluate capital expenditure projects by calculating the internal rate of return (IRR), comparing these results to the minimum acceptable rate of return, also known as the hurdle rate.

If the IRR exceeds the MARR, it is approved. If not, management is likely to reject the project.

As an example, suppose a manager knows that investing in a conservative project, such as a treasury bond investment or other risk-free project, yields a known rate of return.

A risk premium may also be added to this rate if management believes that this specific opportunity involves more risk than other opportunities that could be pursued with the same resources.

When analyzing a new project, the manager can use this conservative project rate of return as the MARR. The manager will only implement the new project if its estimated return exceeds the MARR by at least the risk premium of the new project.

What is the TMAR used for?

When a project is proposed, it must first go through a preliminary analysis to determine whether or not it has a positive net present value, using the MARR as the discount rate.

A manager is more likely to start a new project if the MARR exceeds the existing level on other projects.

This rate is often used synonymously with cutoff rate, benchmark, and cost of capital. It is used to perform preliminary analyzes of proposed projects and is generally increased when there is increased risk.

The MARR is a useful way to assess whether an investment is worth the risks associated with it. To calculate the MARR, different aspects of the investment opportunity must be looked at, including the opportunity to scale up the current operation and the rate of return on investments.

An investment will have been successful if the real rate of return is above the MARR. If it is below that, it is considered a failed investment and, as an investor, you may decide to withdraw from the investment.

It also establishes how quickly the value of money decreases over time. This is an important factor in determining the project’s payback period, by discounting anticipated revenues and expenses at current terms.

MARR calculation

A common method of evaluating a MARR is to apply the discounted cash flow method, which is used in net present value models, to the project.

Internal rate of return

It is the discount rate at which all cash flows from a project, both positive and negative, are equal to zero. The IRR is made up of three factors: the interest rate, a risk premium and the inflation rate.

A company’s MARR calculation starts with the interest rate of a risk-free investment, such as long-term US Treasury bonds.

Since cash flows in future years are not guaranteed, a risk premium must be added to account for this uncertainty and potential volatility.

Finally, when the economy is experiencing inflation, this rate must also be added to the calculation.

weighted average cost of capital

The WACC is determined by the cost of obtaining the funds necessary to pay for a project. A company has access to funds if it takes on debt, increases share capital, or uses retained earnings. Each source of funds has a different cost.

The interest rate on a debt varies depending on current economic conditions and the credit rating of the business.

The cost of equity capital is the return that shareholders require to invest their money in the business.

The WACC is calculated by multiplying the ratio of debt and equity by their respective costs, to arrive at a weighted average.

minimum acceptable rate of return

If a project has an IRR that exceeds the MARR, then management will probably give the go-ahead to proceed with the investment. However, these decision rules are not rigid. Other considerations could change the MARR.

For example, management might decide to use a lower MARR, say 10%, to approve the purchase of a new plant, but require a 20% MARR to expand existing facilities.

This is because all projects have different characteristics. Some have more uncertainty about future cash flows, while others have shorter or longer time frames to earn a return on investment.

Opportunity cost as MARR

Although the WACC is the reference point most used as TMAR, it is not the only one. If a company has an unlimited budget and access to capital, it could invest in any project that simply meets the MARR.

However, with a limited budget, the opportunity cost of other projects becomes a factor to consider.

Suppose a company’s WACC is 12%, and it has two projects: one has an IRR of 15% and the other has an IRR of 18%. The IRR of both projects exceeds the MARR, defined by the CPPC. On this basis, management could authorize both projects.

In this case, the MARR becomes the highest IRR of the available projects under consideration, which is 18%. This IRR represents the opportunity cost against which all other projects must be compared.

Examples of application of a TMAR

Evaluation of a business investment project. A company is considering investing in expanding its product line by acquiring new machinery and technology. Before making the decision, the company must calculate the minimum acceptable rate of return, which could be based on its cost of capital or the expected return on alternative investments. If the projected return of the expansion project exceeds the minimum acceptable rate of return, the company can proceed with the investment.
Evaluation of government bonds. An investment fund evaluates the purchase of bonds issued by a government. To do this, the fund establishes a minimum acceptable rate of return that reflects its level of risk and the interests of its investors. If the interest rate on the bonds exceeds the minimum acceptable rate of return, the fund may decide to purchase those bonds as part of its investment portfolio.
Buying shares on the stock market. An investor is interested in buying shares of a company on the stock market. Before doing so, he sets a minimum acceptable rate of return based on his risk profile and financial goals. If the expected return on the selected shares exceeds the minimum required rate, the investor may decide to purchase the shares.

References

Minimum acceptable rate of return. Retrieved from en.wikipedia.org.
How to Calculate the MARR. Retrieved from bizfluent.com.
Minimum acceptable rate of return. Recovered from revolvy.com.
Minimum Acceptable Rate of Return. Retrieved from staff-old.najah.edu.
Minimum acceptable rate of return. Retrieved from investorwords.com.

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