Chapter 10 - Making Choices & MARR

Developed By: Dr. Don Smith, P.E.
Department of Industrial Engineering

Texas A&M University College Station, Texas
Executive Summary Version
Chapter 10 Making Choices: The Method, MARR, and Multiple Attributes
Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6th Edition, 2005
10-1
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
LEARNING OBJECTIVES
1. Choose a Method 2. Cost of capital and MARR 3. WACC Weighted Average Cost of Capital 4. Cost of debt capital 5. Cost of equity capital 6. High D-E mixes 7. Multiple attributes 8. Weighted attribute methods
10-2
Sct 10.1 Comparing Mutually Exclusive Alternatives by Different Evaluation Methods
Different problem types lend themselves to different engineering economy methods Different information is available from different evaluation methods Primary criteria for what method to apply
Speed
Ease of performing the analysis
See Tables 10-1 & 10-2 for a concise summary

10-3
Evaluation Times
Equal lives of the alternatives
PW, AW, FW
LCM of lives
PW approach
Specified study period

Normally exercised in industry
Infinity (capitalized cost)

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6th Edition, 2005 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
10-4
Decision Guidelines
Select the alternative with:

Numerically largest PW, FW, or AW value For ROR and B/C Apply the incremental analysis approach
10-5
Sct 10.2 MARR Relative to the Cost of Capital

Establishing the MARR within the enterprise Requires:
Cost of equity capital (cost of corporate funds)
Cost of retained earnings included here
Cost of debt capital (cost of borrowed funds)
Debt Capital
$$ acquired from borrowing outside of the firm
Equity Capital
$$ acquired from the owners and retained earnings
10-6
Cost of Capital and the MARR

Established MARR is the sum of:
(expressed as a % cost)
Established MARR
Risk factor added (R%)
Cost of capital +
ER + R%
Expected return +
Risk factor
Expected return (%) ER

CC + x% = ER
MARR will vary from firm to firm and from project to project
Min. MARR
Cost of capital (%) CC

10-7
Factors Impacting the MARR

Perceived project risk
Higher the risk higher the MARR for that project
Investment opportunity
Expansion opportunity may set a lower MARR Maintain flexibility
Tax structure
Higher tax rate higher MARR Federal reserve monetary policy interest rates
Limited capital
Tighter constraints on capital higher MARR
Market rates of other firms

Competitors alter their MARR - the firm could follow suit
10-8
Sct 10.3 Debt-Equity Mix and WACC

D/E ratio (Debt to Equity mix)
Ex.: 40-60 DE = {40% from debt, 60% from equity}
Weighted Average Cost of Capital (WACC)

WACC = (equity fraction)(cost of equity capital)
+ (debt fraction)(cost of debt capital) Both costs are expressed as a percentage cost Example: WACC = 0.6(4%) + 0.6(9%) = 7.8%
A variety of models exist that will approximate the WACC for a given firm
10-9
WACC: Example 10.3

Source of Capital Amount ($) Cost (%)
Common Stock
Retained Earnings
$5 million
$2 million
13.7%
8.9%
Debt from bonds
$3 million
7.5%
Sum: $10 million CS = 50%; RE = 20%; Bonds = 30% WACC = (0.50)(13.7) + (0.20)(8.9) + (0.30)(7.5) = 10.88% This firms MARR must be > 10.88%
10-10
Tax Implications (detailed in Chapter 17)

WACC values are computed:
Before-tax basis
After-tax basis After-tax WACC = (Before Tax WACC)(1- Te)
Where Te represents the effective tax rate
composed of: o Federal rate o State rate o Local rate(s)
10-11
Sct 10.4 Determining Cost of Debt Capital

Debt financing
Loans (borrowing)
$ borrowed from banks $ borrowed from Insurance companies, etc
Issuance of bonds (borrowing) Interest on loans and bonds are tax deductible in the US
Bonds are sold (floated) within a bond market by investment bankers on behalf of the firm Subject to extensive state and federal regulations
Interest payments from the firm to the lenders is tax deductible important cost consideration
10-12
Tax Savings from Debt Financing

The cost of financing by debt is lower than the actual interest rate charged because of the tax deductibility of the interest payments Assume Te = the effective tax rate (%)
Tax Savings = ($ expenses)(Te) Net Cash Flow = {$ expenses - $ tax savings}
NCF
= expenses (1 Te)
See Example 10.4

10-13
Example of Tax Deductibility Impact on Cost of Debt Capital

Assume a loan has a 10% interest rate charged to the borrower
The effective tax rate is 30% The after-tax cost of borrowing at 10% is
(0.10)(1 0.30) = (0.10)(0.70) = 0.07 or 7%
Observations
Due to tax deductibility the effective cost is 7% after tax Higher tax rates result in lower after-tax borrowing rates
10-14
Sct 10.5 Determination of the Cost of Equity Capital and the MARR
Sources of equity capital
1. Sale of preferred stock (PS)
2. Sale of common stock (CS) 3. Use of retained earnings (RE)
RE = past profits retained within the firm

This money belongs to the owners of the firm
Sale of new stock is handled by investment bankers and brokerage firms highly regulated charge the firm for these sales
10-15
Types of Stock
Preferred Stock
A form of ownership
Pays a stated dividend per share periodically Generally a conservative type of stock
Common Stock
A form of ownership Carries more risk than preferred
No guarantee of dividends to be paid
10-16
Cost of Equity Capital

Cost of equity capital generally applies some form of a dividend growth model or valuation model first-year dividend R Basic model e price of the stock expected growth rate
Re = DV1 g P
g is the estimated annual increase in returns to the shareholders

10-17
Capital Asset Pricing Model -- CAPM

Re for equity capital is specified by
Re = risk-free return + premium above risk-free return
Re = Rf + (Rm Rf)
= volatility of firms common stock relative to other stocks
o = 1 is the norm
Rm = return on stocks is a defined market portfolio as measured
by a prescribed index
Rf = quoted US Treasury Bill rate (considered a safe investment)
(Rm Rf) = premium paid above the safe or risk-free rate
See Example 10.6

10-18
Sct 10.6 Effect of Debt-Equity Mix on Investment Risk

D-E mix (Review Section 10.3) As the proportion of debt increasesDue to t the calculated cost of capital tends to decrease
Tax advantage of deducting interest
But..leverage offered by larger percentage of debt capital increases the risks of funding future projects within the company Too much debt is a bad thing Objective strive for a balance between debt and equity funding
10-19
Too Much Debt..

Use of larger percentages of debt capital increases the risk that is assumed by
Investors (owners) and Lenders
Over time, investor confidence in the firm may diminish and the value of the stock could well decline
Difficult to attract new investment funds
Lenders will charge higher and higher interest
rates to hedge the risk

10-20
Sct 10.7 Multiple Attribute Analysis: Identification and Importance of Each Attribute Refer back to Chapter 1 and
7-steps in Figure 10-5
Up to now we have focused on one attribute of a decision making problem

Economic attribute!
Complex problems possess more than one attribute

Multiple attribute analysis is often required
Quantitative attributes Subjective attributes
10-21
Identification of Key Attributes

Must ID the key attributes
Comparison Input from experts
Surveys
Group discussion Delphi methods
Tabulate and then agree on the critical mix of subjective and objective attributes
10-22
Importance of Each Attribute

Determine the extent of importance of each attribute
Implies some form of weighting wi Given m attributes we want:
W
i 1
1.0
Weights for each attribute

Tabular format of attributes vs. alternatives
Value ratings Vi j
10-23
Weighting Methodologies
Equal Weighting
All defined attributes are assigned equal weights Default model May or may not be appropriate
Rank Order
m attributes are ranked in order of increasing importance (1 =
least important; 2, 3, .)
Weighted Rank Order

m attributes ranked in order of importance and apply:
Wi
si
s
i 1
10-24
Value Rating of Attributes

Each alternative is assigned a value rating Vij for each attribute i
Can apply a scale of 0-100 Can apply a Likert Scale
4-5 graduations (prefer an even number of choices)e.g.
o o o o
Very Poor Poor Good Very good
See Table 10.4
10-25
Weighted Attribute Method

n j 1
Sct 10.8 Evaluation Measure for Multiple Attributes

R j WiVij
Selection guideline
Choose the alternative with the largest Rj value
Assumes increasing weights mean more important
attributes Increasing Vij mean better performance for a given alternative
See Example 10.10

10-26
Chapter Summary
Best methods for economic evaluation
PW and AW at the stated MARR
Public projects
Use the B/C ratio
The interest rate used is based upon the cost of capital, mix between equity and debt, and risk levels Multiple attributes incorporate more than objective measures and permit the incorporation of criteria that is not totally economic based
10-27
Chapter 10 End of Set
10-28

Chapter 10 - Making Choices &amp; MARR

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Chapter 10 - Making Choices &amp; MARR

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Developed By: Dr. Don Smith, P.E.

Department of Industrial Engineering

Executive Summary Version

Chapter 10 Making Choices: The Method, MARR, and Multiple Attributes

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Sct 10.1 Comparing Mutually Exclusive Alternatives by Different Evaluation Methods

Ease of performing the analysis

See Tables 10-1 & 10-2 for a concise summary

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Specified study period

Infinity (capitalized cost)

Select the alternative with:

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Sct 10.2 MARR Relative to the Cost of Capital

Cost of debt capital (cost of borrowed funds)

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Cost of Capital and the MARR

Risk factor added (R%)

Expected return (%) ER

Cost of capital (%) CC

Factors Impacting the MARR

Market rates of other firms

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Sct 10.3 Debt-Equity Mix and WACC

Weighted Average Cost of Capital (WACC)

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

WACC: Example 10.3

Debt from bonds

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Tax Implications (detailed in Chapter 17)

Where Te represents the effective tax rate

composed of: o Federal rate o State rate o Local rate(s)

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Sct 10.4 Determining Cost of Debt Capital

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Tax Savings from Debt Financing

See Example 10.4

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Example of Tax Deductibility Impact on Cost of Debt Capital

(0.10)(1 0.30) = (0.10)(0.70) = 0.07 or 7%

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

RE = past profits retained within the firm

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

No guarantee of dividends to be paid

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Cost of Equity Capital

g is the estimated annual increase in returns to the shareholders

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Capital Asset Pricing Model -- CAPM

Rf = quoted US Treasury Bill rate (considered a safe investment)

(Rm Rf) = premium paid above the safe or risk-free rate

See Example 10.6

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Sct 10.6 Effect of Debt-Equity Mix on Investment Risk

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Too Much Debt..

rates to hedge the risk

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Up to now we have focused on one attribute of a decision making problem

Complex problems possess more than one attribute

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Identification of Key Attributes

2005 by McGraw-Hill, New York, N.Y All Rights Reserved

Chapter 10 - Making Choices & MARR

Chapter 10 - Making Choices & MARR