Valuing an MBA Degree: DCF and IRR Analysis

Introduction: The Financial Case for an MBA

A Master of Business Administration (MBA) is generally regarded as a ticket to financial success, and individuals who graduate from top-ranking universities are routinely offered six-figure salaries. Given the high earning potential that an MBA confers, the degree is widely considered extremely valuable — particularly when awarded by a top-ranked U.S. institution. In the United States, MBA graduates often earn twice the salary of pre-MBA graduates from the same university. With such a premium within the labor market, employers frequently offer exceptional compensation to MBA graduates.

However, when analyzing the value of an MBA, it is critical to look beyond starting salary alone. More importantly, the value added by an MBA is estimated by examining the differential between pre-MBA and post-MBA salaries. This valuation approach is analogous to the incremental cash flow analysis used in capital budgeting. For example, a company's decision to purchase a new machine depends on the additional cash flow the new machine will generate compared to the old one. Applying capital budgeting logic to an MBA program, the initial capital investment consists of the foregone income — the salary an MBA student gives up while enrolled — plus tuition and fees paid to earn the degree.

In the United States, MBA tuition ranges from approximately $8,500 per year to over $100,000 per annum. Private universities typically charge the same tuition to both in-state and out-of-state students, whereas public universities practice tuition discrimination, charging lower fees for state residents and higher fees for non-residents (Lawrence & Chad, 2011). The tuition differential at public universities varies widely across states. At some institutions, non-resident MBA students pay only 12% more than state residents; at others, non-residents pay 300% more in tuition than residents for the same degree.

The fundamental objective of this paper is to estimate the financial value of an MBA degree using established capital budgeting techniques.

Valuation Technique for MBA

Valuation models typically used to estimate the value of financial assets are equally applicable to real assets, including human capital. Within finance, analysts use valuation models to calculate the worth of real assets; similar to financial assets, the value of real assets can be determined by the cash flows they generate. The higher the growth rate of those cash flows, and the lower the associated risk, the higher the value of the asset (Fama & Schwert, 1977).

While there are several approaches to valuing real assets, Discounted Cash Flow (DCF) analysis is the most widely used technique in practice. DCF values an asset by applying the concept of the time value of money: future cash flows are discounted back to yield their present value (PV) (Lawrence & Chad, 2011).

This study uses the DCF technique to estimate the value of an MBA. To carry out the financial investment analysis, incremental cash inflows are compared to cash outflows to derive the internal rate of return (IRR). Specifically, the average salary gains attributable to the MBA are compared against the investment in tuition, fees, and foregone salary that students incur. The project cost, therefore, represents the income an individual foregoes by leaving their current job to pursue the degree.

The study draws on data from BusinessWeek (2008), which ranked the top 30 MBA programs in the United States, to estimate tuition and fees. Pre-MBA and post-MBA salaries are then compared to estimate the value of the MBA program. The study does not include living expenses, as these depend on each student's standard of living, personal tastes, and the cost of living near their university. Since these factors vary widely and cannot be standardized, they are excluded from the valuation model.

The study determines the incremental cash flow as follows: the difference between pre-MBA and post-MBA income is calculated to measure the net benefit of the degree. For instance, a student earning approximately $80,000 before entering an MBA program who earns the same $80,000 afterward derives no benefit from the degree. Taking into account all the investment incurred, the MBA would actually produce negative net benefits in this scenario. Similarly, an annual post-MBA salary increase of only 4% on an $80,000 salary yields just $3,200 per year — a modest return relative to the total investment.

The study calculates the cash inflow as the median salary difference between pre-MBA and post-MBA compensation. For example, if a student earned $45,000 before the MBA and $90,000 after, the median salary difference in the first year after graduation is calculated as:

Median Salary Difference = $90,000 − $45,000(1 + 2%)² = $40,920

The incremental salary increase in the second year after MBA graduation is calculated as:

Incremental Salary Increase = [$90,000(1 + X%)¹ − $45,000(1 + 2%)³] = $42,556.80

Conclusion

This paper uses the internal rate of return to demonstrate the financial value of an MBA degree. By evaluating the salary difference between pre-MBA and post-MBA compensation and comparing it against tuition costs and foregone income, the results reveal that an MBA is a valuable degree that significantly increases the internal rate of return for graduates. However, the analysis also demonstrates that the value of an MBA is strongly institution-dependent. While a Harvard MBA graduate earns an average of $230,000 per annum after graduation, an Auburn University MBA graduate earns an average of only $71,000 per year — underscoring the importance of school selection in any rigorous evaluation of the MBA as a financial investment.

References

BusinessWeek. (2008). Business School Comparator. Bloomberg BusinessWeek. USA.

Fama, E. F., & Schwert, G. W. (1977). Asset returns and inflation. Journal of Financial Economics, 5, 115–146.

Forbes. (2012). The Best Business Schools. Forbes Magazine. USA.

International Federation of Accounting. (2008). International Practice Guidance of Good Project Appraisal Using Discounted Cash Flow. Professional Accountants in Business Committee. USA.

Lawrence, J. G., & Chad, J. Z. (2011). Principles of Managerial Finance (13th ed.). Prentice Hall. USA.

White, J. B., Miles, M. P., & White, R. M. (2011). Estimating the internal rate of return on an MBA: A comparison of the return from top-ranked and second-tier programs. Journal of Economics and Finance Education, 10(1), 67–76.