Lecture No. 10 Making Choices: The Method, MARR and Multiple Attributes 1.

Comparing Mutually Exclusive Alternatives

Any method PW, AW, FW, ROR or B/C can be used to select one alternative from two or more and obtain the same correct answer. Only ONE method is needed to perform the engineering economy analysis because any method, correctly performed, will select he same alternative. However, different information is available about an alternative with each different method. See T10-1, p.351 gives a recommended evaluation method for different situations. The primary criteria for selecting a method are: speed and ease of performance. Interpretation of the criteria is as follows: o Evaluation period: The comparison for private projects is over equal or unequal estimated lives, or a specific period. Public projects are typically long lived that may be considered infinite. o Type of alternative: Private sector alternatives are revenue based (includes income and cost estimates) or service-based which is cost estimates only. o Recommended method: The table specifies method such as AW for unequal lives, but the other methods may be subsequently applied to gain more information. o Series to evaluate: Cash flow for one alternative and the incremental series between two alternatives. Once the evaluation method is selected, a specific procedure must be followed. See T10-2, p.350. o Equivalence relation: The basic equation is PW or AW. CC, capitalized cost, is a PW for infinity; FW is determined from PW; AW is PW times A/P. o Lives of alternatives and Time period for analysis: Always one of the following: equal lives, LCM of unequal lives, specified study period or very long lives i.e. infinity. PW always requires LCM of all alternatives. Incremental ROR and B/C methods require the LCM. AW method allows analysis over the respective lives. The one exception is for the incremental ROR method for unequal life alternatives using an AW relation for incremental cash flows. The LCM of the two alternatives compared must be used. o Series to evaluate: Cash flow or incremental series.

Lecture No. 10 Making Choices: The Method, MARR and Multiple Attributes No. 2 o ROR, interest rate: MARR is needed for PW, FW or AW and the discount rate for B/C. o Decision guideline: Always select the alternative with the numerically largest PW, FW or AW. Example 10-1, p.351

2. MARR Relative to the Cost of Capital

MARR is one the most important parameters. The purpose of this section is to explain how to establish a MARR under varying conditions. The cost of each type of capital financing is initially computed separately and then the proportion from debt and equity sources is weighted to estimate the average interest rate paid for investment capital. This percentage is called the cost of capital. The MARR is then set relative to the cost of capital. Other factors such as financial health, expected return are also considered in setting the MARR. If no specific MARR is established, the de facto MARR is set by the projects net cash flow estimates and the availability of funds. The MARR is the opportunity cost which the i* of the first unfounded project. The primary sources of capital are: o Debt capital. Represents borrowing power from outside the company including bonds, loans and mortgages. o Equity capital. Corporate money consisting of owners funds and retained earnings. The setting of the MARR is not an exact process. The MARR is not a fixed value corporate wide. The effective MARR varies from one project to another and through time because of factors which include: o Project risk. The more the risk, the higher the MARR. o Investment opportunity. A lowered MARR may artificially encourage a project. o Tax structure. As taxes increase, the MARR increases. o Limited capital. The more limited the capital, the higher the MARR in accordance with the supply and demand of capital. o Market rates at other corporations. If a competitor changes its MARR, the corporation is pressured to do the same. Example 10.2, p.354.

3.Debt Equity Mix and Weighted Average Cost of Capital

The dept-to-equity, DE, mix identifies the percentages of debt and equity financing for a corporation. A DE of 40/60 has 40% in debt capital (bonds, loans) and 60% in equity capital (stocks and retained earnings). WACC, the weighted average cost of capital

Lecture No. 10 Making Choices: The Method, MARR and Multiple Attributes No. 3 WACC = (equity fraction)(cost of equity capital) + (debt fraction)(cost of debt capital) The cost terms are expressed as a percentage of interest rates. Since all corporations have a mix of capital sources, the WACC is a value between the debt and equity cost of capital.

4. Determination of the Cost of Debt Capital

The cost of debt capital is reduced because there is an annual tax saving of the expense cash flow times the effective tax rate Te. This tax savings is subtracted from the debt capital expense cash flow in order to calculate the cost of the debt capital. Tax savings = (expenses)(effective tax rate) = expenses, Te Net cash flow = expenses tax savings = expenses (1-Te) Example 10.4, p.357

5.Determination of the Cost of Equity Capital and the MARR

Equity capital is usually obtained from the following sources: o Sale of preferred stock o Sale of common stock o Use of retained earnings There are no tax savings for equity capital because dividends paid to stockholders are not tax deductible. With preferred stock, the cost of capital is the stated dividend percentage. Common costs are more complicated: Re = + expected dividend growth rate = + g

6. Effect of Debt Equity Mix on Investment Risk

As the proportion of debt capital increases, the calculated cost of capital decrease due to the tax advantages of debt capital. However, the leverage offered by larger dept capital percentages increases the riskiness or projects. A reasonable balance between debt and equity financing is in order. Example 10.8, p.362

7. Multiple Attribute Analysis

Attributes other than economic. Non-economic attributes tend to be intangible and difficult to quantify. Attribute identification: o Comparison with similar studies

Lecture No. 10 Making Choices: The Method, MARR and Multiple Attributes No. 4 o o o o Input from experts. Surveys of constituencies Focus groups Dephi method

8. Evaluation Measure for Multiple Alternatives

Rank and weight method. Additive method is the most common. Rj = WiVij The W numbers are the attribute importance weights and V is the value rating by attribute i for each alternative j. Choose the alternative with the Rj value.