W3_AL_Project Hurdle Rate

1. Problem Definition

Previous project analysis was analyzed using 12.5% hurdle rate (PSC contractor guideline in proposing project). What is appropriate hurdle rate and NPV for this project?

2. Identify the Feasible Alternative

In order to calculate the PSC contractor’s hurdle rate, calculation is using following formula:

– Capital Asset Pricing Model (CAPM)

– Weighted Average Cost of Capital (WACC)

– Minimum Attractive Rate of Return (MARR)

3. Development of the Outcome for Alternative

Sources of capital alternative could be:

• Equity
• External sources of funds (lender)

4. Selection Criteria

Calculation

CAPM

WACC

MARR

5. Analysis and Comparison of the Alternative

MARR calculation shows that both fund alternatives is feasible to run, this indicate by IRR > MARR, and based on risk categories MARR Standards are guided below (Sullivan, 2012:533)

This project is categorized as moderate risk (MARR < 25%).

6. Selection of the Preferred Alternative

Hurdle rate is determined by funding scheme. If using external source hurdle rate that should be applied is 20.31% (resulting NPV 3,458 MUS$), otherwise hurdle rate 24.07% should be applied for 100% equity scheme (resulting NPV 3,276 MUS$).

7. Performance Monitoring and the Post Evaluation of Result

Since economic analysis should be in real and WACC will be determine by fraction of total capital obtain by debt, range of 12.5% – 24 % hurdle rate can be applied for economic analysis. Whenever there is a change in the financing structure of the project, MARR and NPV calculation shall be performed.

Reference

1. Sullivan, G. W., Wicks, M. E., &Koelling, C. P.(2012). Engineering economy 15th Edition. Chapter 13 The Weighted Average Cost of Capital (WACC), pp.525-533.
2. AswathDamodaran (2014). Country Default Spreads and Risk Premiums. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
3. AswathDamodaran (2014). Betas by Sector. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html
4. Liana, Lita (2014). Using Analytical Hierarchy Process to Determine Appropriate Minimum Attractive Rate of Return for Oil and Gas Projects in Indonesia. Retrieved from http://pmworldjournal.net/article/using-analytical-hierarchy-process-determine-appropriate-minimum-attractive-rate-return-oil-gas-projects-indonesia/
5. Fernandez, Pablo., Aguirreamalloa, Javier., & Linares, Pablo (2013). Market Risk Premium and Risk Free Rate used for 51 countries in 2013.Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=914160