Audio Transcript: Minimum Acceptable Rate of Return (MARR), Explained

Lets talk a little bit about the minimum acceptable rate of return. You may see it as minimum allowable rate of return, but you always find the acronym MARR. So most of the time when you are reading the book or looking through these notes you will see that acronym right there, but its always going to be some kind of interest rate we are going to use for comparison when evaluating projects. Now the minimum acceptable rate of return always represents a kind of opportunity cost. It’s suppose to be something that you can do with your money other than putting it in these projects that you are going to be considering, these possible investments.

And the easiest way that you can think of about this is it’s simply an account that has an interest rate that is associated with it. It’s the same interest rate whether you are taking money out of the account in order to fund investments as when you have extra cash putting it into the account to earn a little bit extra interest, ok? So it’s supposed to be the same interest rate. Now in the real world it usually doesn’t work out that way, but that’s a complication we are not quite going to play with here. So for our evaluations of investments we are always going to be dealing with a single interest rate, even though this could be different over time.

Now in the real world you have many possible sources for this particular interest rate. Here's the general hierarchy you go. The first thing you can do is, ask. If you are a in large organization you can essentially go to accounting and go "hey look, I'm trying to do some costing on this project can you tell me the interest rate you'd like me to use to discount things?" And usually they’ll have some general standard, whatever it may be, and again they'll just tell you what it is.

This also works on other projects when you are dealing with someone who you’re doing work for like a client of some sort. For example, I recently did some work for the Portland development commission and we were dealing with some things like whether they should turn some cabinetry from particleboard into hardwood board. We had to do some time value money calculations and so I asked them what is their usual rate for the minimum acceptable rate of return, they didn't actually have one, but I got to talk to them about what would be appropriate for them. We eventually came up with a number, a percent, so I actually talked the client through the process. Other clients have a standard that’s often going to be published, so if your dealing with government agencies you can ask them where is their publish standard. Often times it will be some kind of reference interest rate that’s there. Dealing with the federal government they publish it so it changes about once a week, so you always have to say "well look I found this in the congressional register on this particular day and they’ll have different interest rates for different ranges. So they’ll have one for projects between 1 and 3 years, and another one for between 3 and 5 and so on down the line. So the protocol, the asking works really well.

Beyond the protocol of asking, what you’re doing then is looking at is, ‘what are the alternate source of funds’. And so if you’re going to be taking out a loan in order to fund your projects, your alternate source of funds could be the loan rate, so it’s essentially what you are being charged to borrow the money, and you can use that to evaluate your projects on whether it’s a good idea or not. Knowing that if you don’t fund that project that means you can actually lower the amount of money you are borrowing and lower the amount of interest you are paying.

Other things you can do are to react to historically what’s happened. Here’s where I suggest you take a look at some accounting ratios and specifically start taking a look at the return on assets and return on common equity. What the return on assets actually represents is what your firm commonly gets from an investment and so it represents the dollars that you get per year of every dollar that you actually invest in a project. It makes sense as a reference interest rate, which you usually get. In practice you don’t use the return on assets directly. In practice what you do is you use something like the return on assets +2%, or the return on assets -2%, depending upon how aggressive you are trying to be about expansion, but the return on assets is a common reference interest rate that you use for deciding whether you are going to go forward. If you don’t have that kind of history or you don’t think its appropriate one of the things you can do is start looking at what common rates of return do I get, what interest rate do I get for the same amount of risk. So if you are looking at some risky projects you can start looking at some risky firms and seeing what are the growth rates of those particular stocks, or what are the dividend rates those firms are using. You can start to dial in on what an appropriate interest rate is.

So these are the sources you are going to have for the minimum acceptable rate of return (MARR), but I just wanted to point out that most of the time the best response on where to get this number is to ask somebody and in this class what I will be doing is most of the time just giving you the appropriate minimum acceptable rate of return.

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