W10.0_RML_Determine Minimum Acceptable Rate of Return (MARR)

1. Problem Definition

Continue from Blog W9, since the MARR = 4.5% seems to small and not suitable with current oil & gas business environment, the Author need to check and calculate the REAL or TRUE MARR that Company should be using.

2. Identify the Feasible Alternative

To calculate MARR, follow 3 steps using below equations:

A. Capital Asset Pricing Model (CAPM)

CAPM provides a formula that calculates the expected return on a security based on its level of risk. The formula for CAPM is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate. The cost of equity is calculated by using CAPM (Rs) formula:

(Equation 1):

B. Weighted Average Cost of Capital (WACC)

WACC is the product of the fraction of total capital from each source and the cost of capital from that source, summed over all sources. WACC formula:

(Equation 2):

C. Minimum Attractive Rate of Return (MARR)

MARR is the lowest return that you would be willing to accept given:

– The risks associated with the project

– The other opportunities for investment

(Equation 3):

3. Outcomes of the Alternative

Sources of capital alternative could be from:

– Debt

– Equity

4. Selection of Criteria

Calculation for WACC based on top biggest 2013 predicted producing oil and gas contractors in Indonesia. Caused the Company is a non-listed company, so it is impossible to estimate stock beta (ßs). Therefore, other methods are required to estimate beta of the private company.

Table 1. Average of Beta and Average of D/E Calculation

To determine stock beta (ßs) follow the steps published by Elvin Mirzayev as published on http://www.investopedia.com/articles/personal-finance/050515/how-calculate-beta-private-company.asp with below equation:

(Equation 4):

With Tax Rate 22%, The Unlevered Beta will be:

In the final step, we need to re-lever the equity using the target D/E ratio of the private company:

And the WACC will be:

By using Analytical Hierarchy Process (AHP) for scoring the risk, we can get risk scoring as shown in table below:

Note: We are not going to perform the AHP process, we are going to use AHP result from Lita Liana (2014) research or calculation since it covers the scope of oil and gas activities in Indonesia.

Table 2. Risk Scoring based on risk matrix rank

Indonesia country risk in 2021 = 1.88% by table below:

Figure 1. Country Default Spreads and Risk Premiums

Criteria for MARR shall be based on calculation of equation 3:

5. Comparison of the Alternatives

Based on risk categories for income-producing projects, normal MARR Standards categories as follows (Sullivan, 2016:555)

1. High Risk – MARR = 25%
2. Moderate Risk – MARR = 18%
3. Low Risk – MARR = 10%

6. Selection of the Preferred Alternatives

Based on criteria for normal MARR Standards categories in (Sullivan, 2016:555), MARR Value (13,72%) falls between Low to Moderate Risk (10% – 18%). Based on data analysis and criteria above we will determine the MARR to be used is 13,72% and will propose to update the Company’s current number.

7. Performance Monitoring and Post Evaluation of Result

MARR values ​​should be used according to location and type of project or investment, as different regions have different risks. Inappropriate MARR values ​​(either too low or too high) can lead to misjudgment of project or investment risks and lead to wrong decisions. MARR values ​​should be updated regularly in line with company strategy and business risk analysis.

Reference:

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