CHAPTER5:

THEMINIMUMACCEPTABLERATEOFRETURN(MARR)andtheCostof

Capital.
Capitalisanecessaryfactorofproduction,andlikeanyotherfactor,ithasacost.Thecostof
eachfinancialcomponentorinstrumentisdefinedasthecomponentcostofthatparticularfinancial
component.Thethreemajorcapitalstructurecomponentsare:debt(bondsandloans),equity(common
stock,preferredstock),retainedearnings.
TheMARRvalueusedinengineeringeconomicanalysisisoneofthemostimportantparameters
ofsuchananalysis.ThecorrectuseandthevalueusedfortheMARRisoftheutmostimportanceto
achievereliabledecisions.
ThesettingoftheMARRforanengineeringeconomicanalysisisnotanexactscience.The
financialstructureofcompanyischangingovertimeanthereforethedebttoequityratiowillchange
andthischangewillinfluencetheMARRvalue.TheMARRvaluecanalsochangebetweenprojects
becauseofchangesintheriskprofilesofprojects.ManagementmightdecidetochangetheMARRvalue
toincreasetherateofreturnorbecauseofidentifiednewrisksinprojects.

5.1.CapitalStructureofaFirm.

Thedebtpartofthecapitalstructureofafirmleveragestheequity
partbyincreasingthetotalfundsavailableforcapitalprojectsaswell
asthepotentialwealthofafirm.

5.1.1.DebtCapital:

DebtCapitalinvolvesbothshorttermandlongtermborrowingof
funds.Interestmustbepaidtothesuppliersofthecapital,anddebt
mustberepaidataspecifiedtime.

Thesuppliersofdebtdonotshareintheprofitsresultingfromtheuseofthe
capital.
Interestpaidfortheuseofborrowedfundsisataxdeductibleexpenseforthe
firm.

5.1.1.1Loans:

Loansareregardedasashorttermfinancialinstrument(n<5years)

Forsimplicityassumethatallinterestpaymentsontheloanaswellasincome
taxesarepaidbyafirmonanannualbasis.
Theaftertaxcostofcapitalforashorttermloanis:

cL iL 1 t

c L after tax cos t of capital for a loan.

iL rate of int erest per year paid on the loan .
t=effective(marginal)incometaxrate
Example:
Therequiredreturntoinvestors cL isnotequaltothecompany`costofdebtsinceinterest
paymentsaretaxdeductible.Asaresult,thecostofdebttothecompanyislessthantherateofreturn
requiredbydebtholders.
AprojectwillbepartiallyfinancedbyloanofsayR1000000andtheinterestpayableonthe
loanis20%compoundedannually.Thetaxrateofthecompanyis28%.Thecostofcapitalforthe
companytousethisloanwouldthereforebe:
c L

i L 1 t 20 1 0 . 28 14 . 4 %

5.1.1.2.Bonds.Facevalue
Fixedinterestperperiod
01n

i
Sellingpriceflotationcost

i
ieffective 1 1
m
i=interestratethatwillensureequivalencebetweenthenetsellingprice,theinterest,andthe
facevalue.
i effective

effectiveinterestrateperperiod

m=frequencyofcompoundingoftheinterestperperiod(oneyear)
t company tax rate
Aftertaxcostofabond= ieffective

1 t

Example:
Acompanyoffersbondstoinvestorstofinanceacapitalproject.Thematuritydateis30years
andthecouponratewillbe12%payablesemiannually.ThebondisofferedtoinvestorsatR1000par
value.Thetaxrateforthecompanyis28%.

i effective

0 . 12

1 1
1 0 . 1236 12 . 36 %
2

Aftertaxcostofabond= ieffective

1 t 12.361 0.28 8.899%

5.1.2.EquityCapital:

Equitycapitalissuppliedandusedbyitsownersintheexpectationthat
aprofitwillbeearned.

Equitycapitalcannotbeobtained,however,unlesstheexpectedrateofreturnis
highenough,atanacceptablerisk,tobeattractivetopotentialinvestors.
5.1.2.1.CommonStock/Shares.

Theownerofashareofcommonstockinacorporationisentitled
toreceivecashdividendsdeclaredbythecompany,aswellasthe
priceofthestockatthetimeitissold.

P0

Div n
PN
Div1
Div 2

.....

2
N
1 ea 1 ea
1 ea 1 ea N

ea rateofreturnperyear(requiredbycommonstockholders(aftertaxcostofequitytothe
corporation).
P0 currentvalueofashareofcommonstock.
PN sellingpriceofashareofcommonstockattheendofNyears.
Ifwenowassumethatdividendsstayconstantoveraninfiniteperiodoftimeand P0 PN :
P0 Div( P / A, ea , )

Div

ea

Thus,ifthecurrentsellingpriceofashareofcommonstockisknownandtheannualdividend
forthepastyearisalsoknown,theaftertaxcostofequity(commonstock)isconservativelyestimated
tobe:
ea

Div

P0

Note:

1 i n 1

i
1
i

P A

Ifnthen: P

A
A
therefore i
i
P

Example:
Ifsomeoftheearningsareretained,thenthecompany`sstockholderswillincuranopportunity
costbecausetheearningscouldhavebeenpaidasdividends,inwhichcasestockholderscouldhave
reinvestedthemoney.Thefirmshouldearnonitsreinvestedearningsatleastasmuchasits
stockholderscouldearnonalternativeinvestmentsofequivalentrisk
Ifacompanywouldfinanceaprojectbyissuingcommonstockorbyretainedearningsatthe
marketpriceofR100,thecompany`scommonsharesatpresent.TheanticipateddividendisR5per
shareandtheinvestorsexpectagrowthrateof10%.TheinvestorsalsoanticipateasharepriceofR120
after3years.

 P0

Div n
PN
Div1
Div 2

.....

2
N
1 ea 1 ea
1 ea 1 ea N

P0

5
51 0.1 51 0.1 120

100
1 ea 1 ea 2
1 ea 3
2

ea 11.44%
Thisresultsimpliesthatifthecompanyistofinancetheprojectbyusingretainedearningsor
sellcommonstocktoinvestors,itwillhavetorealizearateofreturnofatleast11.44%.
5.1.2.2.PreferredStock/Shares.
Because,likedebt,preferredstockcarriesafixedcommitmentonthepartofthe
corporationtomakeperiodicpayments,and,inthecaseofliquidation,theclaimsofthepreferred
stockholderstakeprecedenceoverthoseofthecommonstockholders.Preferredstockistherefore
moreriskytothefirmthancommonstock,butitislessriskythanbonds.

Becausethedividendrateisfixed,themarketvalueofsuchstockislesslikelyto
fluctuate.Thereforetheaftertaxcostofcapitalforpreferencestockcanbe
approximatedbydividingtheguaranteeddividendbytheoriginalparvalueof
thestock.

e P

Div P

PP

Example:
Thecostofpreferredstockisthepreferreddividenddividedbythenetissuingprice.
ThepreferredstockpriceisR100anditpaysdividendofR10.Ifthereisanunderwritingor
flotationcostof2.5%oftheshareprice(R250)thenthenetissuingpriceforthecompanywouldbe
R9750.Thecostofpreferredstockwouldthenbe:
e P

Div P
10

10.3%
PP
100 2.50

5.1.2.3.RetainedEarnings/Ownerscapital.

Theaftertaxcostofretainedearningsisnormallyassumedtobe
thesameasforcommonstock(therateofreturnexpectedby
commonstockholders).

 Theseearnings,whichareequityfunds,donotbelongtothecorporation,but
rathertothestockholders.Theyhavebeenretainedandreinvestedinthefirm
forthepurposeofenhancingfuturegrowthandrevenuesandincreasing
stockholderswealth.Thus,thereisthesameopportunitycostforthesefundsas
wouldoccuriftheshareholdersreceivedthemoriginallyandtheninvestedthem
inadditionalcommonsharesofthecorporation.
5.2.4.EffectofLeverageontheCostofCapital.
Thehigherthelevelofdebt,thelargerthefixedchargesandthehighertheprobabilityof
notbeingabletocoverfixedcharges.Theinabilitytocoverthefixedchargesthenleadsto
ahostofnegativeimpactsandperceptionsonthecorporation.Thegreaterprobabilityof
notcoveringfixedcharges,whichalsoincreasestheprobabilitiesofbankruptcy,willcause
therelationshipbetweenleverageandtheriskmeasurestocurveupmorerapidlythan
withoutthebankruptcyclause.

Withbankruptcyclause
RequiredrateWithoutbankruptcyclause
ofreturn

Premiumforbusinessrisk
Risklessrateofreturn

Debt/equityratio

5.3.TheEffectofLeverageontheComponentCostofDebt.
Thehighertheleverageratio,thehigherthecostofdebt.Thecostofdebtcanbeexpected
toriseatanincreasingratebeyondacertainratioofdebttoequity.

Aftertax
Costofdebt

Debttoequityratio
Thecostofcapitalforacompanywillstarttoincreaseasthedebtratioincreasesifthe
companyborrowlargesumsofmoneytofinanceprojects.Ifacompanyhasonlyafew
projectsthatisnotthatcapitalintensive,itcanfinancethecapitalbudgetwithonlyequity
funds.Incasethecompanyhavealargenumberofeconomicallyviableprojects,the
managementwillhavetogotothefinancialmarkettoacquirethenecessaryfunds.
Dependingonthedebtratioandthefinancialstandingofthecompanywithinthefinancial
constituency,therequiredcostofcapitalcanincrease.AllprojectswithaNPV>0atthe
MARRvaluecanbeconsideredaslongsthebudgetlimitisnotexceeded.Underconditions
ofcapitalrationingthecompany`svaluewillnotbemaximized.Maximizationofthe
company`svaluecanonlytakeplaceifmanagementcanmovetothepointwherethe
marginalprojects`NPViszeroandthereisnocapitalrationingpresent.

5.4.WeightedAverageCostofCapital(WACC).

Theweightedaveragecostofcapital(WACC)ofthepoolisestimatedbytherelativefractionsfromdebt
andequitysources.Ifknownexactly,thesefractionsareusedtoestimatetheWACC.
WACC = (Equity fraction) (cost of equity capital)

+
(Debt fraction)(cost of debt capital)
= (Common stock fraction)(Cost of common stock capital)

+
(Preferred stock fraction)(Cost of preferred stock capital)

+
(Retained earnings fraction)(Cost of retained earnings capital)

+
(Loans fraction)(Cost of loans capital)

+
(Bonds fraction)(Cost of bonds capital)

Sullivan, Wicks, Luxhoj p599

Source of
financing

Short term
debt
Bonds
Common
stock
Preferred
stock
Retained
earnings

Amount
R x 000

Proportion

After Tax
Cost
(Decimal)

3 600

0.0809

Weighted
Cost
(Proportion)
(After tax
cost)
0.0481
0.0039

10 000
24 600

0.2247
0.5528

0.0424
0.1000

0.0095
0.0553

2 000

0.0449

0.08000

0.0036

4 300

0.0967

0.1000

0.0097

44 500

1.0000

WACC =

0.0820

5.5. Diagram for illustration of the composition of the MARR value

AftertaxMARR=BeforetaxMARR(1taxrate)
RelationshipbetweenCostofCapitalandtheMARRvalue:
Established
MARR
value

Risk factor added

Percentage added to
compensate for the
risk involved

Expected return

Percentage added to
make it economically
viable

Minimum MARR
value

Cost of Capital

5.6. Minimum Attractive Rate of Return

Theminimumattractiverateofreturn(MARR)isacutoffraterepresentinga
yieldoninvestmentsthatisconsideredminimallyacceptable.
The minimum attractive rate of return can be viewed as a rate at
which the firm can always invest, since it has a large number of
opportunities that yield such a return. Whenever any money is
committed to an investment proposal, an opportunity to invest that
money at the MARR has been foregone. The MARR is sometimes
considered to be an opportunity cost.
The MARR should not be confused with the cost of capital.
Normally the MARR is substantially higher than the cost of capital.
This difference occurs because few firms are willing to invest in
projects that are expected to earn slightly more than the cost of
capital, owing the risk elements in most projects and because of
uncertainty about the future.
When the interest rate (MARR) used in economic analysis
calculations is raised to adjust for risk or uncertainty, greater
emphasis is placed on immediate or short-term results and less
emphasis on longer-term results. The higher the interest rate or
MARR value the less the influence of any cash flow the further
it is from t=0.(Time value of money).

 Minimum attractive rate of return should be equal to the largest of:

cost of borrowed money ,cost of capital or opportunity cost.
5.6.1. Selecting a Minimum Attractive Rate of Return.

Risk adjusted rates may not work well. When MARR used in
economic analysis calculations is raised to adjust for risk or
uncertainty, greater emphasis is placed on immediate or short
term results and less emphasis on longer-term results.

Example:
0

1000
2000
3000
4000
5000
Present Value:
0%
10%
15%
20%
30%
-15000 -10652.4 -9127.55 -7897.2 -6065.8
-15000 -12093

-10985

-10049

-8550

1000
2000
3000
4000
5000

 Opportunity cost of Capital Approach.

% Return on
Investment

Funds available for investment

Opportunity
Cost of investment 1 3
Not taken

Cumulative Total Cost of Investment

Optimal Capital Budget.

Optimum capital budget

% Return on
Investment

WACC

1 3

Cumulative Total of new Investments

5.6.2. The effective MARR can vary from one project to another
and through time because of:
Project risk
Where there is greater risk(perceived or actual) associated with
proposed projects, the tendency is to set a higher MARR. This
means that there is some concern that the project will not
realize its projected revenue requirements.
Investment Opportunities
If management is determined to expand in a certain area, the
MARR may be lowered.
Tax Structure
If corporate taxes are rising, pressure to increase the MARR is
present.

 Limited Capital
As debt and equity capital become limited, the MARR is
increased. If the demand for limited capital exceeds supply, the
MARR may tend to be set even higher.
Market rate at other corporations
These variations are often based on changes in interest rates
for loans, which directly impact the cost of capital.

Efficient allocation of available funds between divisions inside the

company.

Increasing the economical viability of a project by decreasing the

required rate of return(MARR) for that specific project.

5.6.3.FactorsthatAffecttheWACC.

ThelevelofInterestRate.
Ifinterestratesincrease,thecostofdebtwillincreasebecause
investorswilldemandahigherrateofreturnontheir
investment.Investorswillalsoexpectincreaseddividendsand
thiswillincreasethecostsofcommonandpreferredstock.

TaxRates.
Taxratesareapplicabletocalculatetheaftertaxcostof
capital.Theinterestpayableonaloanistaxdeductibleand
wouldthereforereducethecostofcapitalforthecompany.

CapitalStructureoftheCompany.
Theaftertaxcostofcapitalislowerfordebtthanforequity.A
companycanchangeitscapitalstructurewiththe
understandingthatitwillinfluencetheproportions(weights)
ofeachfinancialinstrumentinthestructureandthereforethe
finalvalueoftheWACC.

TheDividendPolicy.
Thepercentageofearningspaidoutindividendsmayaffecta
stock`srequiredrateofreturn.

 InvestmentPolicy.
Thecostofcapitalisdeterminedbythecompany`sinvestment
profile.Ifthisprofileisgoingtochangeitwillalsoaffectthe
perceivedriskofthecompanybyinvestors.Iftheinvestors
experiencethechangeasanincreaseintheriskinessofthe
company,theywilldemandhighercompensationforthe
increasedriskintheformofhigherdividendsandinterestrates
onloans.

RevisionQuestions.
1. Whatisthecostofcapital?
2. Identifythedifferentcomponentsthatthecostofcapitalcanbecomprisedof.
3. Describetheinfluenceofthedifferentfinancialcomponentsonthevalueofthecostof
capital.
4. Describetheinfluenceofthecapitalstructureonthevalueofthecostofcapital.
5. Supposethatbasicbusinessriskstoallfirmsinanygivenindustryaresimilar.
a. Wouldyouexpectallfirmsineachindustrytohaveapproximatelythesamecost
ofcapital?
b. Howwouldtheaveragesdifferamongindustries?.
6. Whatfactorsoperatetocausethecostofcapitaltoincreasewithfinancialleverage?.
7. Explaintherelationshipbetweentherequiredrateofreturnontheequity/debtratio.
8. Howwouldthevariouscomponentsofcostofcapital,andtheaveragecostofcapital,
belikelytochangeifafirmexpandsitsoperationsintoanew,moreriskyventure?.