W8_Folakemi_Computation of Minimum Attractive Rate of Return (MARR)

1.      Problem recognition, definition and evaluation

The Minimum Appropriate Rate of Return (MARR), also known as the hurdle rate is an interest rate chosen by an organization to maximize its economic well being. The purpose of this write up is to determine the MARR for an organization that has a total available capital of $32,000 and has the following projects that it wants to invest in:

Table 1.Project Investment Requirements

2.      Development [of the feasible alternatives

The three (3) main methods for calculating MARR are:

1. Opportunity Cost Method: This involves capital rationing. It can be done by plotting the cumulative investment requirements of acceptable projects, against the prospective annual rate of profit for each project. By the opportunity cost method, the MARR is the annual rate of profit of the best rejected projec
2. Management Policy: The MARR can be fixed by the top management of the company by issuing a policy. Various considerations will be discussed including capital available for investment, number of acceptable projects available, risks associated with the investment opportunities and type of organization involved. 
3.  Sector Rate: This involves using a fixed acceptable rate for the type of project. There is however no such fixed rates for private sector projects. However in the public sector, there is a federal government (USA) directive that stipulates a 7% rate to be used in economic evaluations for a wide range of federal projects. This 7% rate will be assumed as the sector rate for the purpose of this write up, just for the purpose of comparing alternatives only.

3.      Development of the outcomes for each alternative

The key objective to be achieved in selection of a MARR is that it should maximize the economic well-being of the organization.

4.      Selection of criteria

Using the case study of the entrepreneur that wishes to investment in new sources on income in 2012. The opportunity cost method was used to calculate the MARR as shown in the figure as follows:

Figure 1: Determination of MARR Using Opportunity Cost Method

 

Based on the figure above, the best forgone project has an annual rate of return of 24%. Therefore the MARR is 24%.

5.      Analysis and comparison of the alternatives

Table 2. MARR Based of Different Methods

 

Based on the results in Table 2 above, the MARR selected based on management’s policy is very close to the rate we arrived at using the opportunity cost method.

6.      Selection of the preferred alternative

The opportunity cost method is scientific and therefore more objective than the other two methods. Based on literature reviewed, it is the most popular method of establishing a MARR, especially because it is based on the phenomenon of capital rationing. It is therefore recommended as the method of establishing a reliable MARR.

7.      Performance Monitoring & Post Evaluation of Result

The MARR of 24% will be used along with the External Rate of Return method to evaluate the projects in this case study and the results will be compared with the ones we arrived at in the IRR method used in week 7.

8.      References

• An-Najah Staff. (2010). Minimum Acceptable Rate of Return. Retrieved from: http://staff.najah.edu/sites/default/files/lecture15.pdf
• Sullivan, W. G., Wicks, E.M., & Koelling, C.P. (2012). Engineering Economy (15th ed.) (pp 202-203, 448, 554-555) New Jersey, NJ. Pearson Higher Education, Inc.
•  UCMERCED School of Engineering. (2006). Methods of Calculating Interest: Evaluating Business and Engineering Assets. Retrieved from: https://eng.ucmerced.edu/people/rbales/Courses/ENGR155files/Week07/Week07_1