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CHAPTER 5 / EVALUATING A SINGLE PROJECT
5.2 Determining the Minimum Attractive Rate
of Return (MARR)
The Minimum Attractive Rate of Return (MARR) is usually a policy issue resolved by
the top management of an organization in view of numerous considerations. Among
these considerations are the following:
1. The amount of money available for investment, and the source and cost of these
funds (i.e., equity funds or borrowed funds)
2. The number of good projects available for investment and their purpose (i.e.,
whether they sustain present operations and are essential, or whether they expand
on present operations and are elective)
3. The amount of perceived risk associated with investment opportunities available
to the firm and the estimated cost of administering projects over short planning
horizons versus long planning horizons
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4. The type of organization involved (i.e., government, public utility, or private
industry)
In theory, the MARR, which is sometimes called the hurdle rate, should be chosen
to maximize the economic well-being of an organization, subject to the types of
considerations just listed. How an individual firm accomplishes this in practice is far
from clear-cut and is frequently the subject of discussion. One popular approach to
establishing a MARR involves the opportunity cost viewpoint described in Chapter 2,
and it results from the phenomenon of capital rationing. This situation may arise
when the amount of available capital is insufficient to sponsor all worthy investment
opportunities. The subject of capital rationing is covered in Chapter 13.
A simple example of capital rationing is given in Figure 5-1, where the
cumulative investment requirements of seven acceptable projects are plotted against
the prospective annual rate of profit of each. Figure 5-1 shows a limit of $600 million
on available capital. In view of this limitation, the last funded project would be E,
with a prospective rate of profit of 19% per year, and the best rejected project is F. In
this case, the MARR by the opportunity cost principle would be 16% per year. By not
being able to invest in project F, the firm would presumably be forfeiting the chance to
realize a 16% annual return. As the amount of investment capital and opportunities
available change over time, the firm’s MARR will also change.∗
Superimposed on Figure 5-1 is the approximate cost of obtaining the
$600 million, illustrating that project E is acceptable only as long as its annual rate of
profit exceeds the cost of raising the last $100 million. As shown in Figure 5-1, the cost
of capital will tend to increase gradually as larger sums of money are acquired through
increased borrowing (debt) or new issuances of common stock (equity). Determining
the MARR is discussed further in Chapter 13.
∗ As we shall see in Chapter 11, the selection of a project may be relatively insensitive to the choice of a value for the
MARR. Revenue estimates, for example, are much more important to the selection of the most profitable investment.
Sullivan, William, et al. Engineering Economy, Global Edition, Pearson Education, Limited, 2019. ProQuest Ebook Central,
http://ebookcentral.proquest.com/lib/cuhk-ebooks/detail.action?docID=5725746.
Created from cuhk-ebooks on 2023-03-23 09:20:45.