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482 SELECTIONOF A MINIMUM ATTRACTIVERATEOF RETURN -
during which the real interest rate was negative. Can this be possible? Would anyone
invest money at an interest rate several percentage points below the inflation rate? Well
consider this: when the U.S. inflation rate was 12%, savings banks were paying 51/2%o~
regular passbook deposits. And there was a lot of money in those accounts. While there
must be a relationship between interest rates and inflation, Figure 15-3 suggests that it is
complex.Representative Values of MARRUsed in Industry
We argued that the minimum attractive rate of return should be established at the highest
one of the following: cost of borrowed money, cost of capital, or the opportunity cost.
The cost of borrowed money will vary from enterprise to enterprise, with the lowest,
rate being the prime interest rate. The prime rate may change several times in a year; it is
widely reported in newspapers and business publications. As we pointed out, the interest
rate for firms that do not qualify for the prime interest rate may be 1/z% to several percentage
points higher..
The cost of capital of a firm is an elusive value. There is no widely accepted way
to compute it; we know that as acomposite valuefor the capital structure of the finn,
it conventionally is higher than the cost of borrowed money. The ,cost of capital must
consider the market valuation of the shares (common stock, etc.) of the firm, which may
fluctuate widely,depending on future earnings prospects of the 'firm, We cannot generalize
on representativecosts of capital.
Somewhat related to cost of capital is the computation of the return on total capital
(long-term debt, capital stock, and retained earnings) actually achieved by firms.Fortune
magazine, among others, does an annual analysis of the rate of return on total capital. The
after-tax rate of return on total capital for individual firms ranges from 0% to about 40%
and averages 8%.Business Weekdoes a periodic survey of corporate performance. This
magazine reports an after-tax rate of return on common' stock and retaine~ earnings. We
would expect the values to be higher than the rate of return on total capital, and this is the
case. The after-tax return on common stock and retained earnings ranges from 0% to about
65% with an average of 14%. ,.
When discussing MARR, firms can usually be divided into two general groups. First,
there are firms that are struggling along with an inadequate supply of investment capital or
are in an unstable situation or unstable industry. These firms cannot or do not invest money
in anything but the most critical projects with very high rates of return and a rapid return
of the capital invested. Often these firms use a payback period of one year or less, before
income taxes. For an investment project with a 5-year life, this correspop.ds to about a 60%
after-tax rate of return. When these firms do rate of return analysis, they reduce the MARR to
possibly 25 to 30% after income taxes. There is potentially a substantial difference between
a one-year before-tax payback period and a 30% after-tax MARR, but this appare.ntly does
not disturb firms that specify this type of dual criteria.
The second group of firms represents the bulk of all enterprises. They are in a more
stable situation and take a longer-range view of capital investments. Their greater money
supply enables them to invest in capital investment projects that firms in the first group