Rationing Capital by Rate of Return 523~
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~ Cutoff
~Rate of
'8' Return~o Capital
Budget
CumulativeCost of Projects ($)
FIGURE 17-2 Location of the cutoff rate of return.In Example 17-2,the rate of return was computedfor each project and then the projects were
arranged in order of decreasing rate of return. For a fixed amount of money in the capital
budget, the projects are selected by going down the list until the money is exhausted. Thus
when we use this procedure, we cut off approving projects at the point where the money
runs out. This point is called the cutoff rate of return. Figure 17-2 illustrates the general
situation.
For any set of ranked projects and any capital budget, the rate of return at which the
budget is exhausted is the cutoff rate of return. In Figure 17-2 the cost of each individual
project is smallin comparisonto the capital budget.The cumulativecost curve is a relatively
smooth curve producing a specificcutoff rate of return. Looking back at Figure 17-1,we see
the curve is actually a step function. For Example 17-2, the cutoff rate of return is between
14 and 15% for a capital budget of $650,000.Significance of the Cutoff Rate of Return
Cutoff rate of return is determined by comparison of an established capital budget and the
available projects. One must examine all the projects and all the money for some period
of time (like one year) to compute the cutoff rate of return. It is a computation relating
known projects to a known money supply. For this period of time, the cutoff rate of return
is the opportunity cost (rate of return on the opportunity or project forgone) and also the
minimum attractive rate of return. In other words, the minimum attractive rate of return to
get a project accomplishedisthe cutoff rate of return.
MARR=Cutoff rate of return=Opportunity cost
We generally use the minimum attractive rate of return to decide whether to approve an
individual project even though we do not know exactly what other projects will be proposed
during the year. In this situation, we cannot know whether the MARR is equal to the cutoff
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