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					        CHAPTER 10

MAKING CHOICES: THE METHOD,
     MARR, AND MULTIPLE
        ATTRIBUTES
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 attributes
   Weighted
                      8. Weighted
   Average Cost of
                         attribute methods
   Capital
4. Cost of debt
   capital


                                             2
Sct 10.1 Comparing Mutually Exclusive Alternatives by
Different Evaluation Methods

     Different problem types lend
    themselves to different engineering
    investment analysis 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
                                                        3
4
5
Evaluation Times

   Equal lives of the alternatives
      PW, AW, FW
   LCM of lives
      PW approach
   Unequal lives of the alternatives
      AW approach
   Specified study period
      Normally exercised in industry
   Infinity (capitalized cost)

                                        6
Decision Guidelines

   Select the alternative with:
      Numerically largest
        PW, FW, or AW value

      For ROR and B/C
        Apply the incremental analysis
        approach




                                          7
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        8
Cost of Capital and the MARR


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


                                                                      9
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
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 interest
      rate
     Example: WACC = 0.6(4%) + 0.6(9%) = 7.8%

 A variety of “models” exist that will
 approximate the WACC for a given firm

                                                            11
WACC: Example 10.3
   Source of               Amount ($)                Cost (%)
    Capital
Common Stock $5 million                                13.7%

Retained                $2 million                         8.9%
Earnings
Debt from               $3 million                         7.5%
bonds
           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%
                                                                  12
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:
           Federal rate
           State rate

           Local rate(s)



                                              13
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

                                                           14
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



                                                      15
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


                                                            16
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                  17
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




                                                  18
Cost of Equity Capital

    Cost of equity capital generally applies
   some form of a dividend growth model
   or valuation model
   Basic model R  first-year dividend  expected growth rate
                       e
                          price of the stock
                          DV1
                     Re =      g
                           P

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



                                                            19
    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


                                                                20
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 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



                                                21
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

                                                  22
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



                                                           23
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


                                         24
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



                                                              25
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



                                                          26
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
     See Table 10.4


                                                  27
Sct 10.8 Evaluation Measure for Multiple Attributes
  Weighted Attribute Method
                        n
                 R j   WiVij
                       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
  See Example 10.10
                                                     28
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


                                         29
Assignment for Chapter 10




 Problems #2,4,6,13,15,22,28,36,
  and 44

				
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