the minimum rate of return on a project. a manager or company is willing to accept before starting a project, given its risk and the opportunity cost

Size: px

Start display at page:

Download "the minimum rate of return on a project. a manager or company is willing to accept before starting a project, given its risk and the opportunity cost"

Beatrice Richardson
6 years ago
Views:

2 the minimum rate of return on a project. a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects. investment required by a manager or investor. In order to compensate for risk, the riskier the project, the higher the hurdle rate.

3 Also Known as hurdle rate. The required return in capital budgeting. The minimum return necessary for a fund manager to start collecting incentive fees. The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread. Within a firm, there may be different minimum acceptable rates of return

4 The minimum acceptable rate of return must cover the cost of capital for the alternatives being considered If a firm has a mixture of debt and equity: Weighted average cost of capital establishes a floor for the minimum acceptable rate of return Minimum acceptable rate of return is usually between: Weighted average cost of capital Cost of equity capital There is NO universally accepted method for setting the minimum acceptable rate of return (No single method used by all companies)

5 1. Project risks 2. Investment opportunities 3. Limits on available capital 4. Rate of return at other companies 5. Tax structure

6 Where there is greater risk: Set higher minimum acceptable rate of return! Risk-adjusted minimum acceptable rate of return Higher cost of debt for risky projects: Want extra return on average In case the project does not produce its projected revenues

7 If management wants to expand: Set lower minimum acceptable rate of return! Encourage investment in desired areas

8 As debt and equity capital become limited: Minimum acceptable rate of return increases! Demand for capital exceeds supply: (Basic supply and demand at work!) Opportunity cost plays a role in setting the minimum acceptable rate of return Consider two companies: One with obsolete equipment One with brand-new equipment Which company should have a higher minimum acceptable rate of return?

9 If competitors increase their minimum acceptable rates of return: A company may choose to follow suit And vice versa! These variations are often based on: Changes in interest rates for loans (which directly affect the cost of capital) Federal Reserve monetary policy (changing interest rates charged to member banks) Companies with low minimum acceptable rates of return will tend to invest more in competitiveness!

10 Rising corporate taxes: Due to increased profits, capital gains, changes in local tax rates, etc.) create pressure to increase the minimum acceptable rate of return Not true for after-tax analysis: Apply minimum acceptable rate of return to after-tax costs, revenues

11 Determine the MARR of the company that can borrow funds 8.5% and requires 7% profit margin of return. So we can simply conclude that MARR= 8.5% + 7% =15.5%

12 An NPV result greater than zero means that you will exceed the required rate-of-return (you will exceed the "hurdle rate"), which means the investment is acceptable. Example: A seed investor is considering investing in a startup company. Given the current market conditions, the seed investor chooses to use a hurdle rate between 50% to 100% to compensate for risk. The seed investor considers 2M shares for investing $2M in the startup after determining that the 2M shares will have a potential market value of $37.5/share (less tax) in 5 years. To determine if the seed investor will accept or reject this offering, enter the following numbers below into the calculator above:

13 Hurdle rate: 0.5 Initial Investment: ($2M investment, enter as negative number) Year End 1 through Year End 4 cash flows = 0 (no shares sold until year 5) Year End 5 cash flow (2M shares x ($37.5/share - $7.5/share tax)) Result at 0.5 hurdle rate = (Accept)

14 Hurdle rate: 1.0 Initial Investment: ($2M investment, enter as negative number) Year End 1 through Year End 4 cash flows = 0 (no shares sold until year 5) Year End 5 cash flow (2M shares x ($37.5/share - $7.5/share tax)) Result at 1.0 hurdle rate = (Reject)

15 In financial theory, the return that stockholders require for a company. The traditional formula for cost of equity (COE) is the dividend capitalization model: A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

16 The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.

17 The minimum acceptable rate of return depends on: Cost of capital Mix between debt and equity financing Minimum acceptable rate of return should be at least as large as the weighted average cost of capital: With an allowance for risk And consideration of opportunity costs!

An investment s return is your reward for investing. An investment s risk is the uncertainty of what will happen with your investment dollar.

Chapter 7 An investment s return is your reward for investing. An investment s risk is the uncertainty of what will happen with your investment dollar. The relationship between risk and return is a tradeoff.