MARR and payback period method

Determining Minimum Attractive Rate of Return (MARR):

Minimum Attractive Rate of Return (MARR) is the minimum interest rate at which a firm can earn or burrow money. It is a rate of return that project manager accept before starting a project considering its risk. A project manager will start a new project if MARR exceeds the current return of other projects. The MARR is related to the present value of return on investment and a series of future payments and incomes. It used in time value of money calculation.

It is generally dictated by management considering the following points:

1. The amount of money available for investment and the source and cost of these funds
2. The number of good projects accessible for investment
3. The amount of alleged risk associated with investment
4. The type of organization involved
5. Market assessment

MARR is determined from the opportunity cost viewpoint which results from the capital rationing phenomenon. Capital rationing is the situation where the funds available for capital investment are not sufficient to cover potentially acceptable projects. Opportunity cost is the value for the best-rejected project or the worst accepted resulting the best opportunity forgone.

In general, MARR = project value + rate of interest for loans + expected inflation rate + inflation change rate + loan default risk + project risk

Current return = (Present value of cash inflows + Present value of cash outflows)/Interest rate

Payback Period Method

The payback period method is the initial project screening method whether to pursue a project on the basis of time it takes for net revenues to initial investment expenses. The project is not chosen unless its’ payback period is shorter than some specified period. This time, the limit is set largely by management rules and authority. A computer chip manufacturer would allocate a short time limit for any new investment in high-tech products quickly becomes obsolete. The payback period calculation can take into two forms: may or may not consider the time value of money. The former case is the conventional payback method and the latter case is the discounted payback method.

If the payback period obtained within the acceptable range then a formal project evaluation such as present worth analysis may begin. It is essential to know that the payback screening is not an end in itself but rather a method of screening out certain clearly unacceptable alternatives before progressing to an analysis of potentially acceptable ones.

1. Conventional Payback Period:

This method is the conventional and simple used for determining the relative worth of new production machinery by calculating the time it will take to payback what it cost knowing the annual benefits. If a company makes the decision on investment solely on the basis of the payback period, then those projects with a payback period shorter than the maximum acceptable payback period are chosen.

Payback Period = Initial Investment/ Uniform annual benefits ……… (1)

If the annual benefits are got to be uniform, the payback period can be simply determined by dividing the initial payment or investment by the uniform annual receipts.

Whenever the estimated cash flows vary annually, however, the payback period must be determined by adding the estimated cash flows for each year until the cumulative sum is equal to or greater than zero. The meaning of this procedure can be easily explained. The project will reach the payback point when the cumulative cash flow equals zero at the point where cash inflows will exactly match or payback the cash outflows. When the cumulative cash flows are greater than zero, then the cash inflows will exceed the cash outflows and the project has begun to generate the profit thus surpassing the payback point of the project.

Example to obtain payback period when cash flow is not uniform.

Here, a negative balance of Rs.10,000 remains at the start of year 4. If Rs.45,000 is expected to be received as a continuous flow during year 4, the total investment will be recovered two-tenths (10,000/45,000) of the way through the fourth year. Thus, in this situation, the payback period is 3.2 years.

Benefits and flaws of Payback Period Screening Method:

Benefits:

1. Simplicity
2. Reduces the information search
3. May eliminate some alternatives, thus reduces analyzing time

Drawbacks:

1. Fails to measure profitability of project
2. No consideration of time value of money
3. As payback screening ignores all proceeds after the payback period, it does not allow for the possible benefits of a project with a longer economic life.

2. Discounted Payback Period:

To remedy one of the shortcomings of the conventional payback period method, we may modify the process so that it considers into account the time value of money i.e. the cost of funds (interest) used to support a project. This modified payback period is often referred to as the discounted payback period. Also, we may define the discounted payback period as the number of years that is required to recover the investment from discounted cash flows.

Considering the cash flow of above example and suppose the company requires a rate of return of 15%, then the discounted payback period is calculated as:

Hence, we find that the net commitment to the project ends during year 5. Subject to which cash flow hypothesis we adopt, the project must remain in use about 5 years (year-end cash flows) or 4.2 years (continuous cash flows) in order for the company to cover its cost of capital and also recover the funds it has invested.

The inclusion of effects stemming from the time value of money has increased the payback period by a year for this example. Certainly, this modified measure is an improved one, but it does not show the complete picture of the project’s profitability either.

Merits:

1. Considers the time value of money
2. Considers the riskiness of the project’s cash flow through the cost of capital

Demerits:

1. No solid decision criteria that indicate whether the investment increases the firm’s value
2. Requires an estimate of the cost of capital investment in order to calculate the payback period.
3. Ignores the cash flows beyond the discounted payback period

BIBLIOGRAPHY:

Chan S.Park, Contemporary Engineering Economics, Prentice Hall, Inc.
E. Paul De Garmo, William G.Sullivan and James A. Bonta delli, Engineering
Economy, MC Milan Publishing Company.
James L. Riggs, David D. Bedworth and Sabah U. Randhawa,Engineering
Economics, Tata MCGraw Hill Education Private Limited.