Question

Describe the general approaches that organizations use to define the MARR% interest rate (hurdle rate) used in the capital planning/budgeting/justification process. At a minimum, describe the opportunity cost perspective and the weighted average cost of capital in terms of this process. How do these two concepts differ? Describe what it means to adjust the MARR% rate to account for “risk.” Give examples of how/when this is done. What is the MARR Controversy? What is your opinion of this controversy?

Answer 1

In normal parlance,

MARR = Minimum Attractive Rate of Return- Also called the Hurdle Rate

WACC = Weighing Average Cost of Capital

MARR is a function of interest rates, inflation etc among others

For taking up any project, if the IRR of the project is greater than the MARR, it is approved , else it is rejected

Organizations use IRR, WACC etc as metrics for MARR

The limitations to this argument based on Opportunity cost theory is as follows-

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.

But with limited capital, it will approve Project-2 as it is more beneficial

IRR represents the "opportunity cost"

Attaching a risk-premium for projects considered risky will give us the Risk Adjusted MARR