Making Choices: The Method, MARR, and Multiple Attributes

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 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 10-1
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
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
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)
Decision 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 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
Cost of Capital and the MARR
 Established MARR is Established MARR

Risk factor added (R%)
the sum of: (expressed as
a % cost) ER + R%
 Cost of capital +
 Expected return + Expected return
(%) ER
 Risk factor
 MARR will vary from CC + x% = ER
firm to firm and from
project to project
Min. MARR Cost of capital
(%) CC
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
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
WACC: 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%
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%
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)
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
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
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
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
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
Cost of Equity Capital
 Cost of equity capital generally applies some form

of a dividend growth model or valuation model
Basic model
first-year dividend
Re   expected growth rate
price of the stock
DV1
Re = g
P
 “g” is the estimated annual increase in returns to
the shareholders
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

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
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
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
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
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
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
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 Very Poor
o Poor
o Good
o Very good
 See Table 10.4
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
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
Chapter 10
End of Set

Making Choices: The Method, MARR, and Multiple Attributes

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Making Choices: The Method, MARR, and Multiple Attributes

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Developed By:

Dr. Don Smith, P.E.

1. Choose a Method 5. Cost of equity

 Different problem types lend themselves to

 Equal lives of the alternatives

 Select the alternative with:

 For ROR and B/C

 Established MARR is Established MARR

 Weighted Average Cost of Capital (WACC)

 WACC = (equity fraction)(cost of equity capital)

 A variety of “models” exist that will approximate the WACC

Retained Earnings $2 million 8.9%

Debt from bonds $3 million 7.5%

Sum: $10 million

 The cost of financing by debt is lower than the actual

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

 Cost of equity capital generally applies some form

 See Example 10.6

 Must ID the key attributes

Tabular format of attributes vs.

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