(HM-231) Engineering Economics

[Making Choices: The

Method, MARR, and
Multiple Attributes]

1 Muhammad Qasim 12/10/2019

 LEARNING OBJECTIVES

1. Choose a Method 5. Cost of equity

capital
2. Cost of capital
and MARR 6. High D-E mixes
3. WACC – 7. Multiple
Weighted attributes
Average Cost of
8. Weighted
Capital
attribute methods
4. Cost of debt
capital

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

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)

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
 Established Risk factor added (R%)
MARR is the sum
of: (expressed as a % ER + R%
cost)
 Cost of capital + Expected return
(%) ER
 Expected return +
 Risk factor
CC + x% = ER
 MARR will vary
from firm to firm
and from project Min. MARR Cost of capital
(%) CC
to project
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 $5 million 13.7%

Retained $2 million 8.9%

Earnings
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 firm’s MARR must be > 10.88%
10-10
 Tax Implications

 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:
 Federal rate
 State rate
 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
 Basic model R e   expected growth rate
price of the stock
DV1
Re = 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 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

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 increases Due 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:

m Weights for each

W
i 1
i  1.0 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:

si
Wi  m

s
i 1
i

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.
 Very Poor
 Poor
 Good
 Very good

10-25
 Sct 10.8 Evaluation Measure for Multiple
Attributes
 Weighted Attribute Method
n
R j  WV
i ij
j 1
 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

10-26