TMAR (MINIMUM ACCEPTABLE RATE OF RETURN): WHAT IS IT, CALCULATION - DUDAS - 2025

The TMAR (Minimum Acceptable Rate of Return ) is the minimum return that an investor expects to obtain from an investment, taking into account the risks of the investment and the opportunity cost of executing it in place of other investments.

Therefore, it indicates the minimum rate of profit that a project manager considers acceptable to be able to start a project. Managers apply this concept to a wide variety of projects to determine whether the benefits or risks of one project exceed those of other possible projects.

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The TMAR is generally determined by evaluating the opportunities existing in the expansion of operations, the rate of return on investments and other factors that management considers relevant.

Investment evaluation

Business managers are constantly considering investing in new products and capital expenditures. However, they should have a measure that can help them determine whether these new projects represent a valuable use of company funds.

The TMAR is the target rate in the evaluation of the investment in the project. This is accomplished by creating a cash flow diagram for the project and moving all the transactions on that diagram to the same point in time, using the TMAR as the interest rate.

If the resulting value at that set point is zero or higher, the project will proceed to the next stage of analysis. Otherwise it is discarded. The TMAR will generally increase if there is a higher risk to face.

What is the minimum acceptable rate of return?

In business and engineering economics, the minimum acceptable rate of return is the minimum rate of return on a project that a company is willing to accept before starting the project, given its risk and the opportunity cost of forgoing other projects.

The general formula for the TMAR is: TMAR = project value + loan interest rate + expected inflation rate + changes in inflation rate + loan default risk + project risk.

For most companies, the MARR is the company's weighted average cost of capital (WACC) of the company. This figure is determined by the amount of debt and equity on the balance sheet. It is different for every business.

Project analysis

Managers evaluate capital expenditure projects by calculating the internal rate of return (IRR), comparing these results with the minimum acceptable rate of return, also known as the hurdle rate.

If the IRR exceeds the TMAR, it is approved. If not, management is likely to reject the project.

As an example, suppose a manager knows that investing in a conservative project, such as an investment in treasuries or another risk-free project, generates a known rate of return.

A risk premium can also be added to this rate if management believes that this specific opportunity involves more risk than other opportunities that could be pursued with the same resources.

When analyzing a new project, the manager can use this conservative project rate of return as the TMAR. The manager will only implement the new project if its estimated return exceeds the TMAR by at least the risk premium of the new project.

What is it for?

When a project has been proposed, it must first go through a preliminary analysis to determine whether or not it has a positive net present value, using the TMAR as the discount rate.

A manager is more likely to start a new project if the TMAR exceeds the existing level in other projects.

This rate is often used as a synonym for cutoff rate, benchmark, and cost of capital. It is used for preliminary analysis of proposed projects and is generally increased when there is a higher risk.

The TMAR is a useful way to assess whether an investment is worth the risks associated with it. To calculate the TMAR, different aspects of the investment opportunity must be looked at, including the opportunity to expand the current operation and the rate of return on investments.

An investment will have been successful if the real rate of return is above the MARR. If it is below it, it is considered an unsuccessful investment and as an investor, you could make the decision to withdraw from the investment.

Assessment tool

The TMAR establishes how quickly the value of money decreases over time. This is an important factor in determining the project's capital payback period, discounting anticipated income and expenses to current terms.

Companies operating in industries with more volatile markets could use a slightly higher rate to offset the risk and thus attract investors.

Different companies may have slightly different interpretations of the TMAR. Therefore, when a company and the venture capital company are discussing the appropriateness of investing in a project, it is important that both parties understand this term in a compatible way for this purpose.

How is it calculated?

A common method for evaluating an MRT is to apply the discounted cash flow method to the project, which is used in net present value models.

Internal rate of return

It is the discount rate at which all the cash flows of a project, both positive and negative, are equal to zero. The IRR is made up of three factors: the interest rate, a risk premium, and the inflation rate.

Calculating a company's TMAR begins with the interest rate on a risk-free investment, such as long-term US Treasuries.

Since cash flows in future years are not guaranteed, a risk premium must be added to account for this potential uncertainty and volatility.

Finally, when the economy is experiencing inflation, this rate must also be added to the calculation.

Weighted average cost of capital

The CPPC is determined by the cost of obtaining the funds necessary to pay for a project. A business has access to funds by incurring debt, increasing equity capital, or using retained earnings. Each source of funds has a different cost.

The interest rate on a debt varies depending on current economic conditions and the credit rating of the business.

The cost of equity is the return required by shareholders to invest their money in the business.

The CPPC is calculated by multiplying the ratio of debt and equity by their respective costs, in order to arrive at a weighted average.

Minimum acceptable rate of return

If a project has an IRR that exceeds the TMAR, then management will likely give approval to continue the investment. However, these decision rules are not rigid. Other considerations could change the TMAR.

For example, management might decide to use a lower MARR, say 10%, to approve the purchase of a new plant, but require a 20% MARR to expand to existing facilities.

This is because all projects have different characteristics. Some have more uncertainty about future cash flows, while others have shorter or longer periods of time to get their return on investment.

Opportunity cost as TMAR

Although the CPPC is the most widely used benchmark as a TMAR, it is not the only one. If a company has an unlimited budget and access to capital, it could invest in any project that simply complies with the TMAR.

However, with a limited budget, the opportunity cost of other projects becomes a factor to consider.

Suppose that the CPPC of a company is 12%, and it has two projects: one has an IRR of 15% and the other has an IRR of 18%. The IRR of both projects exceeds the TMAR, defined by the CPPC. On this basis, management could authorize both projects.

In this case, the TMAR becomes the highest IRR of the projects available under consideration, which is 18%. This IRR represents the opportunity cost to which all other projects must be compared.

Limitations

Although IRR and related TMAR are useful tools, there are some limitations. For example, a project may have an IRR of 20%, but with a cash flow duration of only three years.

This can be compared to another project with an IRR of 15%, but with a cash flow that will exist for 15 years. What project should management approve? Using the IRR and the MARR are not helpful in this situation.

Examples

A company needs a $ 5,000,000 computer. To do this, the firm sells government bonds at an interest rate of 8% in order to raise that required amount of money.

The "cost" to obtain the $ 5,000,000 is then 8% of the interest rate you have to pay on the bonds. If this is the only activity at that time, you will have to:

- The base of the minimum acceptable rate of return is 8%.

- The minimum acceptable rate of return will commonly be greater than 8%, but can never be less.

This 8% of the TMAR may be modified upwards in order to take into account additional increases and also:

- Performance above cost.

- Perceived risk.

Most companies use an ARR of 12%, based on the fact that the S&P 500 generally produces annualized returns within the range of 8% to 11%.

References

1. Wikipedia, the free encyclopedia (2019). Minimum acceptable rate of return. Taken from: en.wikipedia.org.
2. Capital (2019). Minimum acceptable rate of return. Taken from: capital.com.
3. Jim Woodruff (2019). How to Calculate the MARR. Bizfluent. Taken from: bizfluent.com.
4. Revolvy (2019). Minimum acceptable rate of return. Taken from: revolvy.com.
5. An-Najah Staff (2019). Minimum Acceptable Rate of Return. Taken from: staff-old.najah.edu.
6. Investor Words (2019). Minimum acceptable rate of return. Taken from: investorwords.com.