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Minimum acceptable rate of return

From Wikipedia, the free encyclopedia Jump to: navigation, search In business and engineering, the minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects.[1] A synonym seen in many contexts is minimum attractive rate of return. For example, suppose a manager knows that investing in a conservative project, such as a bond investment or another project with no risk, yields a known rate of return. When analyzing a new project, the manager may use the conservative project's rate of return as the MARR. The manager will only implement the new project if its anticipated return exceeds the MARR by at least the risk premium of the new project. The hurdle rate is usually determined by evaluating existing opportunities in operations expansion, rate of return for investments, and other factors deemed relevant by management. A risk premium can also be attached to the hurdle rate if management feels that specific opportunities inherently contain more risk than others that could be pursued with the same resources. A common method for evaluating a hurdle rate is to apply the discounted cash flow method to the project, which is used in net present value models. The hurdle rate determines how rapidly the value of the dollar decreases out in time, which, parenthetically, is a significant factor in determining the payback period for the capital project when discounting forecast savings and spending back to present-day terms. Most companies use a 12% hurdle rate, which is based on the fact that the S&P 500 typically yields returns somewhere between 8% and 11% (annualized). Companies operating in industries with more volatile markets might use a slightly higher rate in order to offset risk and attract investors. The hurdle rate is frequently used as synonym of cutoff rate, benchmark and cost of capital. Different organizations might have slightly different interpretations, so when multiple organizations (e.g., a startup company and a venture capital firm) are discussing the suitability of investing in a project, it is vital to make sure both sides' understanding of the term are compatible for this purpose.[2]
What is Prject risk Risk ?
Having the best people execute the plan does not guarantee success. There are a host of external factors which may play a role in determining the outcome regarding whether a project has been successful or not. These are called Project risks. The formal definition of a risk is an event or occurrence that may negatively impact the project.

Investment Opportunity Set

All of the investments that a person or company is able to make at a given point in time. What determines an individual investment opportunity set is largely what the investor is able to afford, whether through equity financing, debt financing, venture capital, or even personal savings.

RATE OF RETURN In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on aninvestment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage. The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a [1] portfolio company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

EXAMPLES

An NPV result greater than zero means that you will exceed the required rate-ofreturn (you will exceed the "hurdle rate"), which means the investment is acceptable. Example: A seed investor is considering investing in a startup company. Given the current market conditions, the seed investor chooses to use a hurdle rate between 50% to 100% to compensate for risk. The seed investor considers 2M shares for investing $2M in the startup after determining that the 2M shares will have a potential market value of $37.5/share (less tax) in 5 years. To determine if the seed investor will accept or reject this offering, enter the following numbers below into the calculator above: Hurdle rate: 0.5 Initial Investment: -2000000 ($2M investment, enter as negative number) Year End 1 through Year End 4 cash flows = 0 (no shares sold until year 5) Year End 5 cash flow 60000000 (2M shares x ($37.5/share - $7.5/share tax)) Result at 0.5 hurdle rate = 5901234 (Accept) Hurdle rate: 1.0 Initial Investment: -2000000 ($2M investment, enter as negative number) Year End 1 through Year End 4 cash flows = 0 (no shares sold until year 5) Year End 5 cash flow 60000000 (2M shares x ($37.5/share - $7.5/share tax)) Result at 1.0 hurdle rate = -125000 (Reject)

So the answer depends on how much risk the investor wants to take. If the investor is willing to accept a 0.5 hurdle rate, then the investment is worthwhile. However, if the investor will only accept a 1.0 hurdle rate, the investment would be rejected. Startups can lower the risk to investors through establishing a solid management team, identifying intellectual property, forming strategic alliances, having a customer base, etc...
Determining the Hurdle Rate For a Food Retailer Company X plc is a FTSE 100 food and drug retailer, listed on the UK stock exchange. The market value of its capital structure components is 12 billion for equity, and 8 billion for debt. The computed by a reputable data agency is 0.9. The UK 3-month Treasury bill rate is 4.5%, and you estimate that the market tends to pay a premium over and above this rate, of 4.7%. The UK corporate tax rate is 30%, and the rate paid by the company on its 10-year bonds is 5.5%. We start by computing X plcs cost of equity capital: re = rf+ (rm rf)re = 4.5% + 0.9 (4.7%) = 8.73% We then compute the proportions of debt and equity in the companys capital structure: D(D + E) = 40% and E(D + E) = 60% We can then compute its weighted average cost of capital: WACC = DD+E rd (1 Tc) + ED + E reWACC = (40% x 5.5% x (1 0.30)) + (60% x 8.73%) = 6.78% Company X plc applies a hurdle rate of 6.78% to projects of average risk, but adds a margin for projects of higher risk such as an investment in a new product line (+ 5%) or a company acquisition (+10%). Conclusion In the real world, most practitioners have little appetite for adjusting the hurdle rate for the multitude of factors advocated so fervently by academics. Excepting the all-equity financed case, company CFOs should typically pursue a CAPM-based weighted average cost of capital, and then make sensible and consistent risk adjustments to determine project hurdle rates. All capital structure components should be expressed at market values, and all costs should be forward looking. A company-wide hurdle rate is probably adequate for many investment projects, although the figure should always be reviewed when dealing with more material, large-scale projects, or indeed corporate restructuring.