Business managers constantly consider investments for new products and capital expenditures. But they need to have a measure that helps them determine if these new projects are a worthwhile use of the company's funds. Managers evaluate capital expenditure projects by calculating the internal rate of return (IRR) and comparing the results to the minimum acceptable rate of return (MARR), also known as the hurdle rate. If the IRR exceeds the hurdle rate, it gets approved. If not, management is likely to reject the project.
For most corporations, the MARR is the company's weighted average cost of capital (WACC). This figure is determined by the amount of debt and equity on the balance sheet and is different for each business.
Internal Rate of Return
The internal rate of return is the discount rate at which all cash flows from a project, both positive and negative, equal zero. The IRR is composed of three factors: the interest rate, a risk premium and the inflation rate. The calculation for a company's hurdle rate starts with the interest rate for a risk-free investment, usually long-term U.S. Treasury bonds. Since cash flows in future years are not guaranteed, a risk premium must be added to consider this uncertainty and potential volatility. And finally, when the economy is experiencing inflation, this rate must also be added to the calculation.
Weighted Average Cost of Capital
The WACC is determined by the cost of obtaining the funds needed to pay for a project. A company has access to funds by taking on additional debt, increasing equity capital or using retained earnings. Each source of funds has a different cost. Interest rates on debt vary depending on current economic conditions and the credit rating of the business. The cost of equity capital is the return that stockholders demand for investing their money in the business. The WACC is calculated by multiplying the proportions of debt and equity by their respective costs to arrive at a weighted average.
Minimum Acceptable Rate of Return
If a project has an IRR that exceeds the MARR, then management would probably give approval to proceed with the investment. However, these decision rules are not rigid; other considerations might change the MARR. For example, management might decide to use a lower MARR, say 10 percent, to approve new plants, but require a 20 percent MARR for expansions to existing facilities. This is because all projects have different characteristics; some have more uncertainty of future cash flows while others have shorter or longer time spans for realizing the return on investment.
Opportunity Cost as MARR
While the WACC is the benchmark most commonly used as the MARR, it is not the only one. If a company has an unlimited budget and access to capital, it can invest in any project that meets the MARR. But with a limited budget, the opportunity cost of other projects becomes a factor. Suppose the WACC of a company is 12 percent, and it has two projects: one has an IRR of 15 percent, and the other has an IRR of 18 percent. The IRR of both projects exceeds the MARR, as defined by the WACC, and on this basis, management could authorize both projects.
In this case, the MARR becomes the highest IRR, 18 percent, of the available projects under consideration. This IRR represents the "opportunity cost" that all other projects must be compared to.
Even though IRR and the related MARR are useful tools, there are limitations. For example, one project might have an IRR of 20 percent, but the cash flows only last for three years. Compare this to another project with an IRR of 15 percent, but the cash flow will exist for 15 years. Which project should management approve? Using the IRR and MARR does not help much in this situation.
The MARR is a valuable metric that business managers use to evaluate the worth of projects. The WACC of a company is usually the standard that is used as a starting point. This method works best when a business has only one project under consideration and has an unlimited budget. But in real life, most businesses have budget constraints and several projects to consider. In this case, the highest IRR of all the projects becomes the MARR instead of using the company's WACC. This is known as the "opportunity cost of capital."