c
  

› There is hardly ever enough cash to

invest in all investment opportunities
› Scarcity of resources makes one to
use the limited resources in an
optimal way
› Problem of rationing capital among
competitive projects is called Capital
Budgeting
› Project › Alternatives
1. Acquire additional 1. Lease an existing building
manufacturing facility 2. Construct a new building
3. Do manufacturing
overseas
1. Purchase semiautomatic
2. Replace old grinding machine
machine 2. Purchase automatic
machine

3. Produce parts for the 1. Make parts in the plant

assembly line
2. Buy parts from a
subcontractor
 ]



› 6ere are several proposals for a GM.

1. The foundry wishes to purchase a new
tool to speed up casting
2. The machine shop asks for new
inspection equipment
3. Improvements must be made in the
paint department to conform to the new
air standards.
4. Office manager needs a new safe.
 
  
1. A. Purchase the foundry equipment
B. Do nothing.
2. A. get the inspection equipment.
B. Do nothing.
3. A. Buy Paint department equipment
B. Do nothing.
4. A. Buy a new safe for the office.
B. Do nothing.
The GM can do any combinations. But do
nothing is always an option.
 c
   



Úor Each alternative Reject alternative Do not reject when
compute when

ROR, i i < MARR i >= MARR

PW at MARR PW benefits < PW PW benefits >= PW

costs costs

Annual cost, EUAC EUAC > EUAB EUAC <= EUAB

Annual benefit EUAB
B/C Ratio B/C < 1 B/C >= 1

NPW at MARR NPW < 0 NPW >= 0

 c
 
 




 ]



Analysis Úixed Input Úixed Neither I or

Method Output O is fixed

PW Maximize PW of Minimize PW of Maximize

benefits costs NPW

AE Maximize Minimize Maximize

equivalent uniform equivalent EUAB - EUAC
annual benefits uniform annual
cost

B/C Maximize B/C ratio Maximize B/C Incremental

ratio B/C ratio

ROR Incremental ROR Incremental Incremental

analysis ROR analysis ROR analysis
 
  c





Project Cost UAB Life Salvage Computed
(000) (000) yrs value ROR, %
(000)
1 100 23.85 10 0 20%
2 200 39.85 10 0 15
3 50 34.72 2 0 25
4 100 20.00 6 100 20
5 100 20.00 10 100 20
6 100 18.00 10 100 18
7 300 94.64 4 0 10
8 300 47.40 10 100 12
9 50 7.00 10 50 14
 c 

› MARR = cutoff ROR = opportunity cost

› Normally we use MARR to accept or reject

projects. If the MARR used is not the
cutoff ROR then we may be rejecting good
projects or accepting bad projects.
› Úor this example cutoff rate is between
14% and 15%. We can take MARR ±
14.5% for future calculations.
 
  




› Lorie and Savage came out with the

following suggestion:
› Use a multiplier, p, to decrease the
attractiveness of an alternative in
proportion to its use of the scarce capital.

Use NPW ± p(PW of costs)

where, p is a multiplier.
 G
 



 
 


› Notethat if p > 0 and large then a
project with NPW >0 may have

[NPW ± p(PW of costs)] < 0 !!!!!

By arbitrarily changing p until all
attractive projects total cost equals
the available capital is the method
used for rationing the limited capital.
Consider the previous example.
 
 
 






 
Project Cost NPW NPW ± Cost NPW ± Cost
(000) (000) 0.2*(PW (000) 0.25*(PW (000)
At 8% of cost) of cost)
1 (2) 100 60.04 40.04 100 35.04 100
2 (6) 200 67.40 27.40 200 17.40 200
3 (1) 50 11.90 1.91 50 -0.59
4 (3) 100 55.48 35.48 100 30.48 100
5 (4) 100 80.52 60.52 100 55.52 100
6 (5) 100 67.10 47.10 100 42.10 100
7 (9) 300 13.46 -46.54 -61.54
8 (8) 300 64.38 4.38 300 -10.62
9 (7) 50 20.13 10.13 50 7.63 50
Total 1300 1000 650
  

› 1, 2, 4, 5, 6 and 9 are selected.
› This solution does not agree with the
solution we found based on ROR
selection.
› The reason for that is that the
interest rate used in the table was
MARR = 8% but not the cutoff rate
of 14.5 % as we determined before.
 Ú 
!
Project cost NPW at Cost of
14.5% selected
project
1 100 22.01 100
2 200 3.87 200
3 50 6.81 50
4 100 21.10 100
5 100 28.14 100
6 100 17.91 100
7 300 -27.05
8 300 -31.69
9 50 -1.28
total 650
 
 
 



› The right method to rank projects is

to rank the independent projects
according to their value of net
present worth divided by the net
present cost. Use MARR as the
appropriate interest rate which
should be a reasonable estimate of
the cutoff ROR.
 
  c




"
c



"
c
 
Project Cost UAB Life Salva Com Comp. NPW/
(000) (000) yrs ge pute NPW at PW of
value d 14.5 % Cost
(000) ROR,
%
1 100 23.85 10 0 20% 22.01 0.220
2 200 39.85 10 0 15 3.87 0.019
3 50 34.72 2 0 25 6.81 0.136
4 100 20.00 6 100 20 21.10 0.211
5 100 20.00 10 100 20 28.14 0.281
6 100 18.00 10 100 18 17.91 0.179
7 300 94.64 4 0 10 -27.05 -0.09
8 300 47.40 10 100 12 -31.69 -0.11
9 50 7.00 10 50 14 -1.28 -0.03
 

"
 


Project NPW/PWC ROR

5 0.281 20
1 0.2201 20
4 0.211 20
6 0.179 18
3 0.136 25
2 0.019 15
9 -0.026 14
7 -0.090 10
8 -0.106 12