Chapter 10 making choices & marr

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6th Edition, 2005

© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved10-1

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



LEARNING OBJECTIVESLEARNING 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



Sct 10.1 Comparing Mutually Exclusive Sct 10.1 Comparing Mutually Exclusive Alternatives by Different Evaluation MethodsAlternatives 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 applySpeedEase of performing the analysis

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



Evaluation TimesEvaluation Times

Equal lives of the alternativesPW, AW, FW

LCM of livesPW approach

Specified study periodNormally exercised in industry

Infinity (capitalized cost)



Decision GuidelinesDecision Guidelines

Select the alternative with: Numerically largest

PW, FW, or AW value

For ROR and B/C Apply the incremental analysis approach



Sct 10.2 MARR Relative to the Cost of Sct 10.2 MARR Relative to the Cost of CapitalCapital

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



Cost of Capital and the MARRCost of Capital and the MARR

Established MARR is the sum of: (expressed as a % cost)

Cost of capital + Expected return + Risk factor

MARR will vary from firm to firm and from project to project Cost of capital

(%) CCMin. MARR

Expected return (%) ER

CC + x% = ER

Established MARRRisk factor added (R%)

ER + R%



Factors Impacting the MARRFactors 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



Sct 10.3 Debt-Equity Mix and WACCSct 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



WACC: Example 10.3WACC: Example 10.3

Source of Capital Amount ($) Cost (%)

Common Stock $5 million 13.7%

Retained Earnings

$2 million 8.9%

Debt from bonds $3 million 7.5%

CS = 50%; RE = 20%; Bonds = 30%

WACC = (0.50)(13.7) + (0.20)(8.9) + (0.30)(7.5) = 10.88%

This firm’s MARR must be > 10.88%

Sum: $10 million



Tax Implications Tax Implications (detailed in Chapter 17)(detailed in Chapter 17)

WACC values are computed:Before-tax basisAfter-tax basis

After-tax WACC = (Before Tax WACC)(1- Te)

Where Te represents the effective tax rate composed of:

o Federal rateo State rateo Local rate(s)



Sct 10.4 Determining Cost of Debt CapitalSct 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 USBonds are sold (floated) within a bond market by investment

bankers on behalf of the firmSubject to extensive state and federal regulations

Interest payments from the firm to the lenders is tax deductible – important cost consideration



Tax Savings from Debt FinancingTax 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



Example of Tax Deductibility Impact Example of Tax Deductibility Impact on Cost of Debt Capitalon 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



Sct 10.5 Determination of the Cost of Sct 10.5 Determination of the Cost of Equity Capital and the MARREquity Capital and the MARR

Sources of equity capital1. 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



Types of StockTypes of Stock Preferred Stock

A form of ownershipPays a stated dividend per share periodicallyGenerally a conservative type of stock

Common StockA form of ownershipCarries more risk than preferredNo guarantee of dividends to be paid



Cost of Equity CapitalCost of Equity Capital

Cost of equity capital generally applies some form of a dividend growth model or valuation model

Basic model

“g” is the estimated annual increase in returns to the shareholders

e

1e

first-year dividendR expected growth rate

price of the stock

DVR =

Pg



Capital Asset Pricing Model -- CAPMCapital 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 firm’s common stock relative to other stocks

= 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



Sct 10.6 Effect of Debt-Equity Mix on Sct 10.6 Effect of Debt-Equity Mix on Investment RiskInvestment 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



Too Much Debt…..Too Much Debt….. Use of larger percentages of debt capital

increases the risk that is assumed by Investors (owners) andLenders

Over time, investor confidence in the firm may diminish and the value of the stock could well declineDifficult to attract new investment fundsLenders will charge higher and higher interest

rates to hedge the risk



Sct 10.7 Multiple Attribute Analysis: Sct 10.7 Multiple Attribute Analysis: Identification and Importance of Each AttributeIdentification and Importance of Each Attribute

Refer back to Chapter 1 and7-steps in Figure 10-5

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

Complex problems possess more than one attributeMultiple attribute analysis is often required

Quantitative attributesSubjective attributes



Identification of Key AttributesIdentification of Key Attributes

Must ID the key attributesComparison Input from expertsSurveysGroup discussionDelphi methods

Tabulate and then agree on the critical mix of subjective and objective attributes



Importance of Each AttributeImportance of Each Attribute Determine the extent of importance of each

attribute Implies some form of weighting – wi

Given m attributes we want:

1

1.0m

ii

W

Value ratings Vi j

Tabular format of attributes vs. alternatives

Weights for each attribute



Weighting MethodologiesWeighting 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:

1

ii m

ii

sW

s



Value Rating of AttributesValue Rating of Attributes Each alternative is assigned a value rating –

Vij for each attribute iCan apply a scale of 0-100Can apply a Likert Scale

4-5 graduations (prefer an even number of choices)e.g.o Very Pooro Pooro Goodo Very good

See Table 10.4



Sct 10.8 Evaluation Measure for Multiple Sct 10.8 Evaluation Measure for Multiple AttributesAttributes

Weighted Attribute Method

Selection guidelineChoose 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

1

n

j i ijj

R WV



Chapter SummaryChapter 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



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Chapter 10 making choices & marr