Analysis of Independent Projects
Minimum Attractive/Acceptable Rate of Return
Cutoff rate
Benchmark rate
Hurdle rate
A MARR is the minimum profit an investor expects to make from an investment, taking into account the risks of the investment and the opportunity cost of undertaking it instead of other investments.
Selecting the MARR
Weighted Average Cost of Capital
Combination of the cost of equity and the cost of debt used to finance the project/investment
Risk Premium
A risk premium is a measure of excess return that is required by an individual to compensate them for being subjected to an increased level of risk.
MARR can be set for the entire corporation, by project, or by division.
MARR values change over time due to...
WACC
Risk associated to the investment
Investment opportunities
Government interventions
Tax structure
Market rates
Bank Loan vs Investment Project
Bank loans money to the customer.
The customer repays the loan to the bank.
The company invests money in the project.
The projects returns the investment to the company.
Payback period
How fast can the intial investment be recovered
Based on the cumulative cash flow
If the payback period is shorter than a maximum acceptable specified payback period, the project would be considered for further analysis.
Present Worth Analysis
The present worth of all cash inflows are compared to the present worth of all cash outflows.
The difference between the present worth of these cash flows is the Net Present Worth (NPW).
Net Present Worth Criteria
An interest rate that a firm wants to earn on its investment is the Minimum Attractive/Acceptable Rate of Return
The MARR is used as the discount rate to calculate the present worth/value of inflows and outflows
Accept the investment when PW(MARR) > 0
Remain indifferent to the investment when PW(MARR) = 0
Reject the investment when PW(MARR) < 0
Borrowed Funds Concept
A firm has to borrow money from the bank to finance the project. So, part of the proceeds from the project will be used to pay off the bank loan.
Annual Equivalent Worth
The cost per year of owning and operating an asset over its entire lifespan.
Multiply the net present worth by the capital recovery factor
The annual equivalent worth can be used to seek consistency of report format, to determine the unit cost or unit profit, and to perform life cycle cost analysis
Accept the investment when AE(i) > 0
Remain indifferent when AE(i) = 0
Reject the investment when AE(i) < 0
Internal Rate of Return
Internal rate of return is a method of calculating an investment’s rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or financial risk.
Break Even Interest Rate
Internal Rate of Return (IRR) is the break-even interest rate i* that equates the present worth of a project’s cash outflows to the present worth of its cash inflows.
Net present worth = 0
Accept the project if IRR > MARR
Remain indifferent if IRR = MARR
Reject the project if IRR < MARR