Minimum acceptable rate of return
Encyclopedia
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. 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.
using the MARR as the discount rate. The MARR is the target rate for evaluation of the project investment. This is accomplished by creating a cash flow diagram
for the project, and moving all of the transactions on that diagram to the same point, using the MARR as the interest rate. If the resulting value at that point is zero or higher, then the project will move on to the next stage of analysis. Otherwise, it is discarded. The MARR generally increases with increased risk.
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment 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...
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. 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
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment 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...
. 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
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
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
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
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
Benchmarking
Benchmarking is the process of comparing one's business processes and performance metrics to industry bests and/or best practices from other industries. Dimensions typically measured are quality, time and cost...
and cost of capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
. 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.
Project analysis
When a project has been proposed, it must first go through a preliminary analysis in order to determine whether or not it has a positive net present valueNet present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
using the MARR as the discount rate. The MARR is the target rate for evaluation of the project investment. This is accomplished by creating a cash flow diagram
Cash flow diagram
A cash flow diagram is a tool used by accountants and engineers to represent the transactions which will take place over the course of a given project. Transactions can include initial investments, maintenance costs, projected earnings or savings resulting from the project, as well as salvage and...
for the project, and moving all of the transactions on that diagram to the same point, using the MARR as the interest rate. If the resulting value at that point is zero or higher, then the project will move on to the next stage of analysis. Otherwise, it is discarded. The MARR generally increases with increased risk.
Typical values
The MARR is often decomposed into the sum of following components (range of typical values shown):- Traditional inflation-free rate of interest for risk-free loans: 3-5%
- Expected rate of inflation: 5%
- The anticipated change in the rate of inflation, if any, over the life of the investment: Usually taken at 0%
- The risk of defaulting on a loan: 0-5%
- The risk profile of a particular venture: 0-50% and higher
See also
- Weighted average cost of capitalWeighted average cost of capitalThe weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
, weighted average cost of capital - Cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
- Internal rate of returnInternal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...