W4_AlShehhi_MARR for Exploration & Production Project in Oman

1. Problem Definition.

In order to decide which option to go with in W3 blog post, the future value (FV) of each option was calculated and that was based on assumed interest/hurdle rate of 10%. In this blog post, it will identified if this rate is appropriate to use in an Exploration and Production project in Oman, by calculating Minimum Attractive Rate of Return (MARR) and re-evaluate previous decision.

2. Identify the Feasible Alternative.

The two alternatives of either outsourcing the project to SME entrepreneur or keeping it In-housed still stand;

1. Outsource
2. In-house the project

As well as the assumed interest rate (10%) or MARR

3. Development of the Outcome for Alternative

The MARR can be calculated with the following formula^[1]:

MARR = WACC + Risk Scoring + Country Risk

Capital Asset Pricing Model (CAPM) is calculated by following formula^[2,3]:

Rs = RF + βs(Rm-Rf)

Where:

• RS = Stock S rate of return
• RF = risk-free rate of return
• βS = contribution of stock S to market risk
• RM = market portfolio rate of return
• (RM– RF) = market risk premium

.

Weighted Average Cost of Capital (WACC) equals^[1]:

WACC = WACC = λ (1 – t) i_b + (1 – λ) e_a

Where:

• λ = the fraction of the total capital obtained from debt
• (1 – λ) = the fraction of the total capital obtained from equity
• t = effective income tax rate as a decimal
• ib = the cost of debt financing, as measured from appropriate bond rates.
• ea = the cost of equity financing, as measured from historical performance of the CAPM

 

4. Selection a Criterion

Due to the fact that risk-free rate does not practically exists, the interest rate of a three-month US treasury bill is assumed as the risk-free rate ^[4,5,6,7].

Rf = 0.03%

βs = 1.24 ^[8]

(RM– RF) = 6.05% ^[9]

Calculating for Rs;

Rs = 0.03% + 1.24 × 6.06% = 7.5%

Since the project is not debt financed, it is 100% equity. Therefore,

WACC = Rs = 7.5%

Country Risk = 1.05% ^[9]

Risk scoring is assumed zero for the purpose of this blog. This is a reasonable assumption as risk contribution is relatively low compared to WACC and country risk.

MARR = 8.6%

5. Analysis and Comparison of the Alternative.

It was found that calculated MARR (8.6%) is lower than previously assumed (10%). This means that 10% is not always real, although sometimes being more conservative. This could lead to assigning conservative capital budget/investment, which is not always a great thing to do.

However, by the definition of interest rate, new calculated MARR will not affect investment decision as it was based on future value (FV). FV’s for both options would reduce proportionally, see Table1.

Table1: FV using both 10% and MARR as interest rate

6. Selection of the Preferred Alternative.

MARR is the preferred option as it is more realistic.

7. Performance Monitoring and the Post Evaluation of Result.

Risk scoring/evaluation be considered in MARR equation in the future, debt and tax rating to be considered in WACC also because not all companies can afford pure equity financing.

8. References:

1. Gideon, (2014, March 29). W5.0_GW_Drilling a Well Hurdle Rate_Kristal AACE2014, Retrieved on June 24, 2014, from http://kristalaace2014.wordpress.com/2014/03/29/w5_gw_drilling-a-well-hurdle-rate/comment-page-1/
2. Finance Formulas, Capital Asset Pricing Model, Retrieved on June 24, 2014, from http://www.financeformulas.net/Capital-Asset-Pricing-Model.html
3. Complete Guide to Corporate Finance, Retrieved on June 24, 2014, fromhttp://www.investopedia.com/walkthrough/corporate-finance/5/cost-capital/cost-equity.aspx
4. Risk-Free Rate of Return, Retrieved on June 26, 2014, from http://www.investopedia.com/terms/r/risk-freerate.asp
5. Treasuries Interest Rate, Retrieved on June 26, 2014, from   http://www.barchart.com/economy/treasuries.php
6. Three-Month Treasury: Secondary Market Rate, Retrieved on June 26, 2014, from http://research.stlouisfed.org/fred2/series/TB3MS/
7. 3 Month Treasury Bill: 0.03% for June 25, 2014, Retrieved on June 26, 2014, from http://ycharts.com/indicators/3_month_t_bill
8. Damodaran, Total Betas by Sector (for computing private company costs of equity), Retrieved on June 26, 2014, from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/totalbeta.html
9. Damodaran, Country Default Spreads and Risk Premiums, Retrieved on June 26, 2014, fromhttp://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html