Estimating the Internal Rate of Return on an MBA: A Comparison of the Return from Top-Ranked & Second-Tier Programs potx

This study estimates the internal rate of return for the top 30 MBA programs and 15 second-tier MBA programs in the United States by comparing cost of acquiring the degree with the incre

Estimating the Internal Rate of Return on an MBA:

A Comparison of the Return from Top-Ranked & Second-Tier Programs

ABSTRACT

An MBA is frequently touted as a ticket to financial success

Top ranked programs often promote the starting salaries of their graduates, with the implication that investing time and money in their MBA program will produce a significant return This study estimates the internal rate of return for the top 30 MBA programs and 15 second-tier MBA programs in the United States by comparing cost of acquiring the degree with the incremental post-MBA income over an expected work life of 40 years The rates of return range from 11 percent to over 40 percent, with the rates of return not significantly correlated to a program’s ranking

Introduction

The master of business administration (MBA) is acknowledged to be a very valuable degree, especially if it comes from a top-ranked university It is not uncommon for the starting salary of an MBA to

be nearly twice that of an undergraduate from the same institution This is an incredible increase in income from a two-year degree that is not the result of significant career shift Consequently, applicants covet admission slots in top ranked programs, as they are viewed as tickets to the “fast track” of financial success Universities, likewise, seek to be included in the “top ranked” or “best” list because an unbiased, third party endorsement is the most effective marketing A high ranking also increases the number of qualified applicants for the university to select from, which tends to further enhance an MBA program’s reputation

However, when analyzing the financial value of an MBA, the starting salary of the graduate is only part of the equation The value added by the degree is the function of the differential between the pre-MBA salary and the post-MBA salary This is somewhat analogous to the incremental cash flow analysis in capital budgeting The decision to buy a new machine depends not on the cash flow the new machine produces but the additional cash flow it produces over the old machine

Extending the capital budgeting analysis to evaluate MBA programs, the initial capital investment would be the opportunity costs including foregone income and associated salary increases, as well as the tuition and fees associated with the university Tuition and fees vary greatly among the top 30 MBA programs The tuition and fees range from less than $9,000 per year to more than $50,000 per year

Further complicating the issue of the value of the MBA is the price discrimination practiced by public universities While private universities tend to charge the same tuition for all students, residency plays a role in the price at public universities The tuition for a resident of the state is less than that of someone who is classified as a non-resident The tuition differential varies greatly across states For example, at The University of Virginia, a non-resident pays only 12 percent more for the degree than a resident pays

1 John B White, Ph.D Professor of Finance, United States Coast Guard Academy

john.b.white@uscga.edu, 860-941-5784, , (Contact author); Morgan P Miles, D.B.A Professor of Enterprise Development,

University of Tasmania, Locked Bag 1316, Launceston, Tasmania, 7250Australia; Roger M White, University of Pittsburgh 

Georgia Institute of Technology (Georgia Tech) represents the other extreme A non-resident pays more than 300 percent more than a Georgia resident for the same degree

The purpose of this study is to evaluate the MBA from a specific university as an investment that pays dividends over a lifetime of employment The dividend from the degree is the additional salary that results from the degree, while the cost of the investment is the foregone income and associated tuition and fees The internal rate of return (IRR) on the MBA degree from the top 30 programs in the United States, as well

as 15 other programs designated as “second-tier” programs (ranked and published in BusinessWeek

magazine) will be calculated Programs will then be ordered by their IRR, and this ranking will be

compared to the BusinessWeek ranking

This study lies at the intersection of the literature dealing with the value of human capital development, the determination of quality of academic programs, and the basics of capital budgeting Specific interest centers on the economic value of an MBA and how that value varies with the quality of the program, as determined by some external ranking This economic value can be translated into an internal rate of return by comparing the costs of the degree (the initial investment) with the subsequent income (cash-flows) over the individual’s work life (the life of the project)

Literature Review

The connection between education and income is well established Anecdotal and empirical evidence supports what parents and teachers always said, “You need an education to get a good job.” Francese [2002] reported that family incomes for college graduates were nearly double the family incomes of high

school graduates The difference is even greater for those with advanced degrees The Wall Street Journal

[2009] examined the returns to specific graduate degrees An MBA averaged the highest rate of return at 29 percent, followed by lawyers (25.4%) and physicians (21%) The return to the MBA was enhanced by the shorter time required to earn the degree (2 years) than a law (3 years) or medical degree (at least 4 years) Davies and Cline (2005), looking at data from 1993-2000, calculated the breakeven point and the internal rate of return for the average student receiving an average AACSB-accredited MBA The breakeven period was estimated to be approximately nine years for the period under observation The internal rate of return

on an average MBA was approximately 18 percent, which exceeded the average return to the Dow Jones Industrial Average Payback is generally regarded as a very poor technique when evaluating capital budgeting projects, and its deficiencies make these results suspect Comparing the 18 percent MBA return

to the Dow Jones Industrial Average is questionable since the risk level associated with the two investments is not equivalent

In addition, these studies looked at degrees in general and did not differentiate among the schools that issued these degrees, but, there is no doubt that an MBA from an elite program offers more opportunities than lower or unranked programs Carpenter’s study [1998] evaluated the school-specific return to the top twenty Canadian MBA programs Her results were limited by the fact that she only considered the seven year period from when a student began the program, and used the payback period as her metric, with shorter paybacks implying a better return The top twenty Canadian MBA programs differ in length, ranging from eleven months to 24 months Obviously, shorter programs begin paying back the initial investment much quicker than longer programs This bias towards a quick payback further exacerbates the fact that payback does not incorporate nor consider cash-flows beyond the payback period

The Wall Street Journal [2009] followed a similar approach in an evaluation of accelerated MBA

programs that are international in scope First, accelerated programs were ranked based on the survey results from students and alumni The study examined a graduate’s income for the five years after the MBA was received The return is based on the difference between pre-MBA income and post-MBA income and compared to the investment cost - the program’s tuition and fees Both pre-MBA and post-MBA incomes were assumed to increase at 4 percent annually; however, since the return from an MBA is expected to have an effect on salaries for more than five years, this truncated analysis distorts the return on the educational investment Also, the assumption of a common 4 percent salary growth rate is illogical A more reasonable assumption would be that the income growth rate for someone who holds an MBA would be higher than for those who do not hold that degree Finally, excluding foregone income from the expenditure side of the analysis ignores a significant aspect in the analysis

Gerdes [2009] calculated an alternative measure of return, salary per tuition dollar, for the top public and private undergraduate business programs Using data from 2008 business school undergraduates, the

median starting salary was divided by the annual tuition and fees required by the program In-state tuition rates were used for public institutions Average starting salaries for business undergraduates were nearly identical for the top 50 public universities and the top 50 private universities ($53,346 vs $53,222) Public universities provided a much higher ratio of average starting salary per tuition dollar because of their lower tuition rates This analysis, while developing a unique measure of return, focuses only on the initial salary and fails to capture the return from future salary growth

BusinessWeek [2008] provides the most comprehensive data to support its determination of the top

thirty business programs It reports the usual academic information, such as median GMAT and the acceptance rate of the incoming class, and certain financial information, such as the median incomes of students by school before and after the MBA and the program’s cost (tuition and fees) A final aspect of the rankings, the percentage of students that have a job offer at graduation, is also reported The final ranking depended most on a program’s selectivity (GMAT and acceptance rate) and the post-MBA salary

The BusinessWeek ranking and its associated data are shown in Table 1 The original BuisnessWeek data

only included non-resident tuition and fees

Gloeckler (2010) expanded the BusinessWeek published salary data for the top 30 MBA programs and

the fifteen second-tier programs by estimating median salaries shortly after graduation (less than two years), as well as at the five-year, ten-year, fifteen-year, and twenty-year marks after the degree was earned These median salaries are the result of a survey of more than 23,000 MBA graduates that yielded salary growth projections over the twenty-year period and then projected the future salaries of current graduates These data are also included in Table 1

TABLE 1

20 YRS Growth ($)

Northwestern

Pennsylvania

10 8

UC-Berkeley

17 17

North Carolina

Southern

19 16

Carnegie Mellon

20 26

Notre Dame

21 20

Texas-Austin

Brigham Young

U of Washington

28 27

Washington

29 NA Georgia Tech 684 50 55.0 95.0 146.0 2.172% 64152

2nd

Tier NA

Arizona State

2nd

2nd

2nd

Tier NA

George

2nd

Tier 22

Georgetown

2nd

Tier 29

Michigan State

2nd

2nd

2nd

2nd

Tier NA

UC-Irvine

2nd

2nd

Tier NA

Illinois-Urbana

2nd

2nd

Tier NA

Minnesota

2nd

1 Tuition and all required fees for entire program Where applicable, out-of-state costs are listed Excludes living

expenses

2 Median salary only; does not include signing bonus, stock options, or other compensation

Based on respondents to student survey; does not represent entire graduating class

Methodology

Estimating the value of an MBA involves a number of factors When financial investments are

evaluated, the cash outflows are often compared to the incremental cash inflows and the internal rate of

return is derived This type of analysis can be used to evaluate MBA programs The average return from an

MBA from various schools, which would compare the investment of two years of tuition and fees, plus

foregone salary to the additional earning potential, would certainly be of interest to prospective MBA

students

For an MBA, the project’s cost is represented by the foregone income from the jobs left and the

required tuition and fees The top thirty programs are all four semester programs, where students are

admitted in the fall semester (August/September) of the first year and graduate at the conclusion of the

spring semester (usually May) of the second year Thus, the initial investment is represented by the two

years of tuition and fees that must be paid Since these MBA students were already working, the investment

cost also includes the value of the two years of income that is foregone by returning to school

This study uses the BusinessWeek (2008) data on tuition and fees, as well as pre-MBA and post-MBA

salaries to determine the internal rate of return on an MBA from BusinessWeek’s top-ranked MBA

programs The top thirty programs were ranked, while fifteen additional second-tier programs are also included for comparison purposes, making a total of 45 programs in the study Ten of the top thirty programs are at public institutions, while 9 of the second-tier programs are state supported

While a student’s official state of record is assumed to have no effect on salary, it often has a significant effect on cost Public universities often have higher tuition for out-of-state students than in-state students This difference in cost will result in a different internal rate of return for a public university program, depending on whether the student is classified as a state resident or non-resident Therefore, two internal rates of return will be estimated for the public university MBA programs evaluated Brigham Young University, a private institution, charges a lower tuition for students who are members of the Church

of Jesus Christ of the Latter Day Saints (LDS or Mormons) than non-church members Therefore, two internal rates of return for BYU will also be calculated A total of 65 internal rates of return are estimated Living expenses are not considered in this study’s estimate of the internal rate of return to an MBA First, the relevant living expenses to include are the additional living expenses incurred Since it is impossible to know a student’s location prior to the MBA program, it is impossible to estimate how much those expenses have changed In addition, it is possible to live cheaply in high cost areas Some may opt for a living situation that includes several roommates, which is considerably less expensive than living alone Thus, the standard of living an MBA student may choose is unknown For these reasons, living costs are not included in the IRR estimates A potential MBA student should realize that moving from a low cost area to a high cost area while holding living standards constant will reduce the return to their specific MBA investment

The benefit from the MBA is not simply the post-MBA income Capital budgeting looks at incremental cash flows Thus, the MBA’s value results from the difference in income pre-MBA and post-MBA If a student had an income of $75,000 when entering an MBA program and graduated with a job offer of $75,000, then the MBA has produced no additional income In fact, the student has been economically disadvantages due to the loss of annual raises An annual raise of only 4 percent implies an income of $81,120 in two years ($81,120 = $75,000 x (1.04)2) If a student began an MBA program earning

$75,000 per year and expected 4 percent growth rate, then any salary less than $81,120 implies they would have been better off without the earning an MBA

It is assumed that once the MBA is earned, the post-MBA salary will grow The growth rate for an MBA from a specific program will be estimated from the data in Table 1 The difference between the starting salary and the twenty-year salary will be used to capture the growth rate for a career Likewise, the assumption is made that salaries would also have increased at 2 percent had the individual had not stopped working to earn an MBA While the 2 percent salary growth rate may seem low, an average salary growth rate of 2 percent for a 40-year work life is no small accomplishment It would result in an income at retirement of over twice the initial salary Thus, averaging a 2 percent salary increase for forty years is not

as insignificant as it may seem

The internal rate of return resulting from the MBA will take the tuition and fees for a particular university plus the pre-MBA salary (which is growing at 2%) as the cash outflows in years 0 and 1 The cash inflows will be the difference between the pre-MBA and post-MBA median salary as reported by the

institution to BusinessWeek For instance, if the pre-MBA salary is $50,000 and the post-MBA salary is

$95,000, then the difference the first year after graduation will be $40,920 [ = $95,000 - $50,000(1 + 2%)2]

The incremental salary increase in the second year $42,556.80 [ = $95,000(1 + X%)1 - $50,000(1 + 2%)3],

where X% is the program specific estimate of the salary growth rate Since the MBA degree is often earned

when students are in their mid to late twenties, a 40-year work life is also assumed

A final question is whether students with higher pre-MBA salaries make the right choice going to the highly ranked program that offered higher post-MBA salaries? Would they have earned a higher IRR from

a lower-ranked program that is less expensive? Would a lower tuition cost coupled with a lower incremental salary combine to yield a higher IRR? The IRR will be calculated taking student data and matching their median pre-MBA salaries with the median post-MBA salaries at less expensive and lower ranked programs

RESULTS

The 20-year annual income growth rates averaged 2.4 percent Harvard had the highest annual growth rate at 3.3 percent, while Iowa was the lowest at 1.3 percent Income growth estimates from the top 30 programs averaged 2.5 percent, while salaries from second-tier programs were expected to grow nearly 2.2 percent annually These average growth rates for executives with top-tier MBAs makes the 2 percent growth rate for non-MBAs seem quite reasonable

The internal rates of return on investing in a top ranked and second-tier MBA, ranging from more

than 40 percent down to 13.44 percent, are shown in Table 2 Public universities and Brigham Young

University have two IRRs since they have two-tier tuition systems Eight of the top ten internal rates of

return are from second-tier schools, with the highest return going to Michigan residents at Michigan State

(which was a second-tier program in the BusinessWeek list) Only eleven of the top thirty returns are from

BusinessWeek’s top thirty programs Twenty-two of the thirty highest returns are public institutions

Table 2

33 17 17 North Carolina (Kenan-Flagler)Res 23.17% 43,053

Res = In-state resident tuition and fees

LDS = Latter Day Saints Church member who qualifies for the lower tuition and fees

The high returns to public institutions are from two distinct aspects of their programs First, the tuition and fees are generally less than their private counterparts For instance, Michigan State’s in-state tuition and fees are $29,359 for two years, and only $58, 365 for a non-resident Chicago and Harvard, on the other hand, are $97,165 and $101,660 respectively for the same two-year period The median tuition for

BusinessWeek’s top 15 programs is $93,568, while the median tuition for the fifteen second-tier schools is

$72,184 The higher required investment reduces the rate of return for a common cash flow

But the MBA’s from the various programs are not viewed as a homogeneous product Indeed, the median post-MBA income for a Chicago graduate is $105,000 per year, while the Harvard median salary is

$121,000 The median post-MBA salary from the top 15 programs is $110,000 The second-tier schools have a median MBA income of $90,000, with only three of the second-tier schools reporting post-MBA incomes of over $90,000

Likewise, the students are not homogeneous with regard to background The higher-ranked schools attract students that are leaving higher paying jobs than their counterparts attending the second-tier schools

BusinessWeek’s top fifteen schools had a median per-MBA income of $70,000, while the second-tier

median was only $45,000 before their MBA

Since the incremental cash inflow from an investment in an MBA is the differential between the pre- and post- MBA salary, the top ranked programs are victims of their own success Highly ranked programs tend to attract more experienced students from higher paying positions The median incremental gain in income (the difference between post MBA salary and pre-MBA salary) was $35,000 for the top ranked programs but $40,000 for the schools in the second-tier (For simplicity, no adjustment was made for time value of money in the two-year differential between the pre and post MBA salary.)

When the higher income differential for the second-tier programs was combined with their lower median tuition, it is not surprising that the second-tier schools have a consistently higher return The correlation coefficient between the IRR and the percentage change in income (pre-MBA vs post-MBA) is

92 percent

Finally, these results do not imply that students who attend highly ranked programs are making irrational financial decisions The median income for an entering student at the University of Pennsylvania (Wharton) was $80,000, with an expected median IRR of 18.36 percent over a 40-year career Had this student been attracted by the higher IRR and enrolled at the University of Michigan, he/she could have expected a median post-MBA salary of only $93,000; however, a candidate who was accepted by Wharton but chose to attend Michigan State would have given up an $80,000 pre-MBA salary to earn only $93,000 two years later A Michigan State MBA would yield this candidate an IRR of only 12.45 percent if he/she qualifies for in-state tuition, and only 11.44 percent return if he/she must pay non-resident rates This is considerable less than the 18.36 percent associated with an MBA from Wharton Thus, it appears that it is quite rational for students leaving higher paying positions to gravitate toward the programs with the higher post-MBA salaries

Conclusion

This study has taken the top 45 MBA programs in the United States, as ranked in 2008 by

BusinessWeek, and has evaluated the costs and cash inflows associated with earning the degree as an

investment Tuition and fees and two years of foregone income were used as the cost of the investment The incremental salary was calculated and used as the investment’s cash inflows

This study has several limitations The salary data are from a single year, which may have been adversely effected by the economic recession The results may be different during an economic expansion However, the analytical framework for estimating the return on an MBA remains the same

The salary data also were collected from voluntary student surveys, with less than 100 percent participation; however, these data were considered to be of sufficient validity to warrant publication by

BusinessWeek, a highly respected publication For a student contemplating an MBA, there is no better

salary information available Furthermore, schools use these rankings in marketing, and prospective students use the information as part of their decision- making processes

The assumption in using survey data is that there is no non-response bias The results derived from the limited response rate are the same results that would have come from a response rate of 100% A test for non-response bias is to segment the responses as they are received Early responses are then compared to

the late responses, with an assumption that late respondents are similar to non-respondents Businessweek

does not indicate that there is any non-response bias in their data

Salary data also do not include the value of options and bonuses that may occur in the future These additional sources of income can be very significant, as news reports indicate These bonuses tend to be

outliers, which is what makes them so newsworthy The median salary projection is a more reasonable expectation of what the future holds

To the extent that a student is significantly different from the median student at a particular institution, the internal rate of return should be adjusted accordingly For instance, if a student enters with a salary that

is lower than the median, he/she could expect a larger salary increase, which would increase his/her IRR If the student is substantially older than the median, then he/she could expect a shorter post-MBA career to enjoy the higher salary, which would lower his/her IRR

Certain schools tend to have areas of expertise in different aspects of business For instance, Wharton MBAs also tend to gravitate to investment banking and financial consulting If that is a student’s career goal, then it is quite rational to attend a program that fits their interests, as opposed to seeking to maximize the return on investment

The results suggest that the “best” business school for a particular student is not necessarily the school that

is ranked most highly, nor the institution whose graduates have the highest incomes at graduation A prospective student’s current salary is a factor in the equation, as the pre-MBA income will be one of the determinants of his/her incremental income The other, the post-MBA income, is a function of the school, the candidate, and the state of the economy (GDP growth rate, unemployment, etc.) at graduation State residency status is also a factor and provides a significant financial incentive to staying close to home Some state universities’ MBA programs offer significant returns to their residents Students considering an MBA would be wise to consider each of these factors

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