Engineering alternatives are evaluated upon the prognosis that a reasonable ROR can be expected. Therefore, some reasonable rate must be established for the selection criteria (step 4) of the engineering economy study (Figure(1–1)).
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return established for the evaluation and selection of alternatives. A project is not economically viable unless it is expected to return at least the MARR. MARR is also referred to as the hurdle rate, cutoff rate, benchmark rate, and minimum acceptable rate of return.
Figure (1–12) indicates the relations between different rate of return values. In the United States, the current U.S. Treasury Bill return is sometimes used as the benchmark safe rate. The MARR will always be higher than this, or a similar, safe rate. The MARR is not a rate that is calculated as a ROR. The MARR is established by (financial) managers and is used as a criterion against which an alternative’s ROR is measured, when making the accept/reject investment decision.
Figure (1-12): Size of MAAR relative to other rate of return values
In general, capital is developed in two ways—equity financing and debt financing. A combination of these two is very common for most projects.
Equity financing: The corporation uses its own funds from cash on hand, stock sales, or retained earnings. Individuals can use their own cash, savings, or investments. In the example above, using money from the 5% savings account is equity financing.
Debt financing: The corporation borrows from outside sources and repays the principal and interest according to some schedule, much like the plans in Table (1–1). Sources of debt capital may be bonds, loans, mortgages, venture capital pools, and many others. Individuals, too, can utilize debt sources, such as the credit card (15% rate) and bank options (9% rate) described above.
Combinations of debt-equity financing mean that a weighted average cost of capital (WACC) results. If the HDTV is purchased with 40% credit card money at 15% per year and 60% savings account funds earning 5% per year, the weighted average cost of capital is
For a corporation, the established MARR used as a criterion to accept or reject an investment alternative will usually be equal to or higher than the WACC that the corporation must bear to obtain the necessary capital funds. So, the inequality
must be correct for an accepted project. Exceptions may be government-regulated requirements (safety, security, environmental, legal, etc.), economically lucrative ventures expected to lead to other opportunities, etc.
Often there are many alternatives that are expected to yield a ROR that exceeds the MARR as indicated in Figure (1–12), but there may not be sufficient capital available for all, or the project’s risk may be estimated as too high to take the investment chance. Therefore, new projects that are undertaken usually have an expected return at least as great as the return on another alternative that is not funded. The expected rate of return on the unfunded project is called the opportunity cost.
The opportunity cost is the rate of return of a forgone opportunity caused by the inability to pursue a project. Numerically, it is the largest rate of return of all the projects not accepted (forgone) due to the lack of capital funds or other resources. When no specific MARR is established, the de facto MARR is the opportunity cost, i.e., the ROR of the first project not undertaken due to unavailability of capital funds.