Tom, the owner of Burger Palace, determined that his weighted average cost of capital is 8%. He expects a return of 4% per year on all of his investments. A proposal presented by the owner of the Dairy Choice next door seems quite risky to Tom, but it is an intriguing partnership opportunity. Tom has determined that the proposal’s “risk factor” will require an additional 3% per year return for him to accept it.
(a) Use the recommended approach to determine the MARR that Tom should use and explain how the 3% risk factor is compensated for in this MARR.
(b) Determine the effective MARR for his business if Tom turns down the proposal.
(a) MARR = WACC + required return = 8% + 4% = 12%. The 3% risk factor is
considered after the project is evaluated, not added to the MARR
(b) Evaluate the project and determine the ROR. If it is 15% and Tom rejects the proposal,
his MARR is effectively 15% per year.
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