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Questions and Answers
What is the primary purpose of economic study methods?
What is the primary purpose of economic study methods?
- To regulate market conditions
- To analyze financial and economic aspects of projects, policies, or business decisions (correct)
- To increase government spending
- To create new financial policies
Economic study methods are exclusively used in academic research and have no practical application in industries.
Economic study methods are exclusively used in academic research and have no practical application in industries.
False (B)
What does MARR represent in the context of investment decisions?
What does MARR represent in the context of investment decisions?
- The average market return rate
- The risk-free rate of return
- The lowest acceptable rate of return for an investment (correct)
- The maximum possible return on investment
A higher MARR generally leads to more projects being considered financially viable.
A higher MARR generally leads to more projects being considered financially viable.
MARR helps determine whether to ______ or reject a project.
MARR helps determine whether to ______ or reject a project.
Which of the following is NOT a factor that influences MARR?
Which of the following is NOT a factor that influences MARR?
A company with an aggressive growth strategy might set a higher MARR to ensure maximum profitability.
A company with an aggressive growth strategy might set a higher MARR to ensure maximum profitability.
What are the two primary components used to estimate MARR?
What are the two primary components used to estimate MARR?
Risk premium is the additional return investors expect for taking on a ______ level of risk.
Risk premium is the additional return investors expect for taking on a ______ level of risk.
According to the calculations provided, what is the MARR if the WACC is 8% and the risk premium is 4%?
According to the calculations provided, what is the MARR if the WACC is 8% and the risk premium is 4%?
In Net Present Value (NPV) analysis, a project is considered acceptable if the NPV is less than 0 when using MARR as the discount rate.
In Net Present Value (NPV) analysis, a project is considered acceptable if the NPV is less than 0 when using MARR as the discount rate.
A company with a high cost of capital is evaluating a project with significant environmental risks. Which approach to setting MARR would be most appropriate?
A company with a high cost of capital is evaluating a project with significant environmental risks. Which approach to setting MARR would be most appropriate?
Explain how market volatility influences the determination of MARR. In a highly volatile market, a company should typically ______ its MARR to account for increased uncertainty and potential losses.
Explain how market volatility influences the determination of MARR. In a highly volatile market, a company should typically ______ its MARR to account for increased uncertainty and potential losses.
Two mutually exclusive projects are being evaluated: Project A has a higher NPV but also a higher initial investment, while Project B has a lower NPV and a lower initial investment. The company should always choose Project A because NPV is always the deciding factor.
Two mutually exclusive projects are being evaluated: Project A has a higher NPV but also a higher initial investment, while Project B has a lower NPV and a lower initial investment. The company should always choose Project A because NPV is always the deciding factor.
Match each component of the WACC formula with its description.
Match each component of the WACC formula with its description.
A company is analyzing a project with an initial investment of $500,000 and annual cash inflows of $150,000 over 5 years. If the MARR is 10%, what is the Net Present Value (NPV) of the project closest to?
A company is analyzing a project with an initial investment of $500,000 and annual cash inflows of $150,000 over 5 years. If the MARR is 10%, what is the Net Present Value (NPV) of the project closest to?
Cost of capital includes both the company's cost of financing from debt and ______.
Cost of capital includes both the company's cost of financing from debt and ______.
The sole factor in project feasibility is whether its IRR surpasses the MARR.
The sole factor in project feasibility is whether its IRR surpasses the MARR.
When evaluating two mutually exclusive projects with identical initial investments, which approach offers the MOST insight when applying the MARR concept?
When evaluating two mutually exclusive projects with identical initial investments, which approach offers the MOST insight when applying the MARR concept?
Outline how changes in market interest rates might impact a business's MARR (Minimum Attractive Rate of Return).
Outline how changes in market interest rates might impact a business's MARR (Minimum Attractive Rate of Return).
Flashcards
Economic Study Methods
Economic Study Methods
Methods used to analyze financial and economic impacts of projects, policies, or business decisions.
Minimum Attractive Rate of Return (MARR)
Minimum Attractive Rate of Return (MARR)
The lowest acceptable rate of return for an investment.
Investment Decision-Making
Investment Decision-Making
Helps to decide to either accept or reject a project.
Risk Management
Risk Management
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Cost of Capital
Cost of Capital
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Market Conditions
Market Conditions
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Company's Financial Strategy
Company's Financial Strategy
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Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC)
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Risk Premium
Risk Premium
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Economic Study Methods
Economic Study Methods
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Net Present Value (NPV)
Net Present Value (NPV)
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Internal Rate of Return (IRR):
Internal Rate of Return (IRR):
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Benefit Cost Ratio (BCR)
Benefit Cost Ratio (BCR)
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Study Notes
Economic Study Methods
- These methods are used to analyze the financial and economic aspects of projects, policies, or business decisions.
- Economic study methods help assess feasibility, costs, benefits, risks, and overall economic impact.
- These methods are commonly used in industries like engineering, business, and government planning.
- Examples of methods include: Minimum Attractive Rate of Return, Present Worth, Future Worth, Annual Worth, Internal Rate of Return, External Rate of Return, Discounted Payback Period, and Benefit/Cost Ratio.
Minimum Attractive Rate of Return (MARR)
- MARR is the lowest acceptable rate of return a company or investor is willing to accept for an investment and "maximizes returns while managing risk".
- It serves as a benchmark to evaluate a project's financial viability.
- MARR is also known as the hurdle rate, cutoff rate, or minimum acceptable rate of return.
- MARR helps determine whether to accept or reject a project, and ensures only investments with sufficient returns are selected.
- It is used in Net Present Value (NPV), Internal Rate of Return (IRR), and Benefit-Cost Ratio (BCR) calculations.
Factors Influencing MARR
- Cost of Capital: Includes the company's cost of financing from debt and equity.
- Risk Level of the Project: Higher risk projects require a higher MARR.
- Market Conditions: Inflation, interest rates, and economic stability affect MARR.
- Company's Financial Strategy: Aggressive growth companies may set a lower MARR.
Determining MARR
- MARR is typically estimated using the Weighted Average Cost of Capital (WACC) plus a risk premium.
- WACC + Risk Premium.
- The average rate that a business pays to finance its assets.
- WACC is calculated by averaging the rate of all the company's sources of capital (both debt and equity), weighted by the proportion of each component.
- Risk premium refers to the additional return or compensation investors expect to receive for taking on a higher level of risk compared to a relatively safer investment (free-risk asset such as government bonds).
WACC Formula
- WACC = ((E/(E + D)) * Re) + ((D/(E + D)) * Rd * (1 - T))
- D = Debt
- Rd = Cost of Debt
- T = Tax Rate
- E = Equity
- Re = Cost of Equity
- To account for uncertainties, a company adds a risk premium to WACC.
Sample Problem
- A company is evaluating a potential investment and needs to determine its MARR.
- Equity (E) = PHP 1,500,000.
- Debt (D) = PHP 1,000,000.
- Cost of Equity (Re) = 14%.
- Cost of Debt (Rd) = 9% (before tax).
- Corporate Tax Rate (T) = 25%.
- Risk Premium = 3% (added to WACC to account for project risk).
- Calculate the Weighted Average Cost of Capital (WACC)
- Use WACC + Risk Premium to calculate the Minimum Attractive Rate of Return (MARR).
MARR in Economic Study Methods
- Net Present Value (NPV): If NPV > 0 (using MARR as the discount rate), then the project is acceptable.
- Internal Rate of Return (IRR): If IRR > MARR, then the project is feasible.
- Benefit-Cost Ratio (BCR): A project is desirable if BCR > 1 when using MARR.
Example Calculation
- A company is considering a project with the following attributes:
- Initial Investment = PHP 500,000
- Annual Cash Inflows = PHP 150,000
- MARR = 10% per year
- Project Life = 5 years
- NPV= PA – P
- Using NPV or IRR, evaluate whether to accept or reject the project based on MARR.
- PA = A × (1 − (1 + i)¯n) / i
- NPV = PHP 568, 618.02 – 500,000
- NPV = PHP 68, 618.02
- Since NPV is positive (PHP 68,618.02), the project is acceptable because it will generate more value than the initial investment.
Sensitivity Level of MARR
- A higher MARR means fewer projects qualify.
- A lower MARR means more projects seem attractive.
- Adjustments to MARR can be made depending on economic trends.
Key Takeaways
- The Minimum Attractive Rate of Return (MARR) is a crucial financial benchmark for investment decisions.
- MARR ensures that only profitable and viable projects are selected by considering risk, market conditions, and financial strategy.
- Understanding MARR helps companies make sound economic choices in project evaluation.
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