For the follow up of CfH comment about my Week 5th Blog posting, in this posting I will discuss about the value of Minimum Attractive Rate of Return (MARR) as our basis to determine whether the projected rate of return of having student pick up service business is attractive enough to be proceeded or not.
In this posting the determination of MARR is based on an assumption that the investment is fully funded by equity of personal investor. For the next blog posting, I plan to put assumption that the fund will be mixed between equity and debt (borrowed fund) to discuss about the Weighted Average Cost of Capital (WACC).
As personal investor, we have some limited alternative investments, considered low risk is like state bonds, bank deposits, and gold deposits and for the one considered high risk is like paper equity stocks.
Investors commonly expect to have projected rate of return in line with risk of investment they face. The more risk they have, the more rate of return they expect. Considering that, the writer use Capital Asset Pricing Model (CAPM) as the basis here to determine MARR and take beta value from the listed company that has similar business/ risk with Student Pick-Up Service.
Based on equation on page 527 of Engineering Economy book
where R is the CAPM return depends upon its risk relative to the market
RF is the risk free rate
βS is the level of market risk
RM is the market return
Refer to Trading Economic, BI rate that associated as risk free rate in Indonesia is 7.25%.
Refer to Country Default Spreads and Risk Premium update January 2013 that published at website: www.stern.nyu.edu, the Risk Premium in Indonesia is 8.8%
Refer to similar type business (Cipaganti Travel) in Jakarta Stock Exchange, the Beta ratio of transportation sector is 0.6
So then the cost of equity reflected by the risk of the business is
= 7.25% + 0.6 * 8.8% = 12.53%
MARR Before Tax = MARR After Tax / (1 – Tax Rate)
Maximum Progressive Income Tax is 30%
So then MARR Before Tax
= 12.53% / (1 – 30%) = 17.9%
Setting Minimum/ Selection Criteria
Traditionally workers who has no side business just put their money in bank deposit which is the interest is very low, only max 5.25% (today rate).
That bank deposit rate of return, even cannot cover the inflation rate of Indonesia: 8.40%
Analysis/ Comparison of the Alternatives against the Criteria
In my week 5th blog posting, the value of MARR: 15% was only based on my assumption/ feeling.
Based on above calculation acceptable rate of return 15% is enough to compare with opportunity of bank deposit and able to cover the inflation rate. But it is NOT enough to cover the risk based on CAPM and income tax.
Selection of the Best/ Preferred Alternative Compared against the Criteria
The justified calculation for minimum acceptable rate of return value based on above is 17.9%
Performance Monitoring and Post Evaluation of Result/ Follow up Assessment
Based on my week 5th blog posting, the pessimistic rate of return for student pick-up service is 18.26%.
It is slightly higher than MARR: 17.9%. So this projected business is justified to be proceeded.
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- Humphreys, Gary C. (2002), Project Management Using Earned Value. 2nd ed., USA: Humphreys & Associates, Inc.
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