MARR - Major issues What is MARR? What is the cost of...

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Unformatted text preview: Major issues What is MARR? What is the cost of capital? What is the relation between cost of capital and financing funds? How can we measure the cost of capital? MARR, IRR and the cost of capital Minimum requirements of acceptability (MARR) The interest rate or discount rate that should be used to estimate cash flows for several competing alternatives is the minimum attractive/acceptable rate of return (MARR). MARR is also called the cost of capital. The determination of MARR is generally controversial and difficult. An easy method to compute for determining what is alleged to be the minimum rate of return is to determine the rate of cost of each source of funds and to weight these by the proportion that each sources constitutes of the total. MARR: example If 1/3 of the capital of a firm is borrowed at 6% and the remainder of its capital is equity earning 12%, then the alleged minimum rate of return is 1 3 3 2 6% + 12% = 10% MARR and capital budgeting MARR determination is a task of capital budgeting. Capital budgeting is a critical function that takes place at the highest level of management. It can be defined as: The series of decisions by individual economic units as to how much and where resources will be obtained and expended for future use, particularly in the production of future goods and services. However, many decisions at the lower level in the management hierarchy affect those proposals competing in the overall capital budget. For example, before a major project is considered in top management capital budgeting process, usually many sub-alternatives of design and technical specifications are considered and the related decisions have been made. The scope of Capital Budgeting The scope of capital budgeting addresses 1. how the money is acquired and from what sources 2. how individual capital project opportunities (and combination of opportunities) are identified and evaluated 3. how minimum requirements of acceptability are set 4. how final project selections are made, and 5. how post-mortem reviews are conducted MARR calculation There are different school of thought relatively to how MARR can be calculated. 1. if particular projects are to be undertaken using borrowed funds, then the minimum rate of return should be based on the rate of cost of those borrowed funds alone; 2. the minimum rate of return should be based on the cost of equity funds alone, on the grounds that a firm tends to adjust its capitalization structure to the point at which the real costs of new debt and new equity capital are equal (see E. at which the real costs of new debt and new equity capital are equal (see E....
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MARR - Major issues What is MARR? What is the cost of...

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