Module 7: Incremental Method

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 7
 MARR
 Incremental Analysis

2 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

The Minimum Attractive Rate of Return
 The Minimum Attractive Rate of Return
(MARR) is the rate at which an entity can
always invest. MARR is set as the result of a
policy decision by the entity, which
represents the entity’s profit objective.
 MARR is set a based on entity’s view of future
opportunities along its financial situation:
 MARR too low  may allow proposal that is
marginally productive or result in a loss.
 MARR too high  may result in rejecting
investment that would have good returns.


3 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Establishing MARR
 An entity (corporation) accumulates funds
(capital) by means of two sources: debt
financing, equity financing, or the mix of the two
 Debt financing refers to capital borrowed from
other party that will be paid back at stated
interest by a specific date.
 No direct risk involving the lender on repayment of
funds and interest, or profits resulting from the
funds
 (short, medium, long) terms loans, bonds, mortgage
 Capital financing represents capital owner by the
corporation used to generate revenue.
 Sales of common or preferred stocks for public
corporations
 Own money for private companies
4  Retained earning SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Establishing MARR
 For capital budgeting and alternative evaluation MARR (the
cost of capital) is set calculated independently for each
type of financing
 The interest rate paid for (cost capital) for mixed financing is
calculated from weighted proportion of source of financing
 Weighted Average Cost of Capital:

WACC = ( equity fraction) x ( cost of equity
 capital) + (debt fraction) x (cost of
Example :
debt capital)
A company is deciding to increase its capital in order to
finance an alternative investment. With a 40-60 D-E mix with
debt costing 8.5% and equity costing 10%, calculate WACC.

WACC = (40%)(8.5%) + (60%)(10%) = 9.4%

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Establishing MARR
 MARR is then set based on that cost, which
reflects the view and/or preference of the
entity (corporation) toward alternatives of
investment
 The MARR varies from one alternative to
another, because of:
 Project risk  which should return higher that
MARR
 Sensitivity of project area  lowering MARR in
one area may provide incentive to encourage
investment in other area
 Tax structure  tax adds to the reduction of net
income
6  Capital-financing method  demand
SI-4251 Ekonomi – supply
TeknikMuhamad for
Abduh, Ph.D.
Incremental Analysis
 With respects to MARR, where unlimited
investment opportunities yielding return at the
MARR is extended into the future, it can be
assumed that the proceeds produced by the
current investments can be invested at the
minimum attractive rate of return.
 The decision for selection of alternatives is based
on the analysis of the difference between
mutually exclusive alternatives.
 The incremental investment analysis considers all
feasible alternatives (that is yielding return >
MARR), starting from the least cost investment.

7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Incremental Analysis
Fund of $ 1,500,000 is available for investment. MARR is set


at 15%
 Alternative P: investment $ 1,000,000 @ 21% return
 Alternative Q: investment $ 1,400,000 @ 18% return
 Alternative R: investment $ 1,250,000 @ 20% return

Alternati Investmen Yield Remaining Yield Total Return
ve t ($ K) Fund
Rate Return ($ Rate Return Yield RoR
(%) K) (%) ($ K) (%)
P 1,000 21 210
($ K.0) 500 15 75.0 285($.0 K) 19.0
Q 1,400 18 252.0 100 15 15.0 267.0 17.8
R 1,250 20 250.0 250 15 37.5 287.5 19 . 2

8 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Incremental ROR – Net Cash Flow Tabulation
 Rate of return can be calculated from cash flow
tabulation of individual alternative.
 Selection of alternatives is done by sequential
comparison of two alternatives, starting from
the lowest to the next higher initial investment.
For positive cash flow, start with “do nothing”
alternative
 Net cash flow (difference between two cash flow)
is to be used to calculate incremental ROR

Net cash flow = cash flow B - cash flow

9
A = 0  i AB SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Incremental Investment:
Net Cash Flow Tabulation

Cash Flow A Cash Flow B Cash Flow ( B - A )

Initial cost - 125,000,000 - 157,750,000 -32,750,000
End of year 1 -9,800,000 +2,800,000 12,600,000
End of year 2 +21,750,000 +11,000,000 -10.750,000
End of year 3 +45,900,000 +65,500,000 19,600,000
End of year 3 +88,750,000 +82,750,000 -6,000,000
Salvage value +75,000,000 +95,000,000 20,000,000
PW C/F @ 10%

Higher initial cost

10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Example
 Three alternatives investment are being
considered at MARR 12%
X Y Z
Initial cost - 650,000,000 -540,000,000 -720,000,000
Yearly expenses - 135,000,000 -123,500,000 -130,000,000
Yearly revenues 330,000,000 321,000,000 357,500,000
Salvage value 45,000,000 52,000,000 202,000,000
period 5 5 5

(yearly cash flow) 195,000,000 197,500,000 227,500,000

11 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Solution
Y X Z
comparison “do nothing” to Y
Incremental cost, P -540,000,000
Incremental C/F, A 195,000,000
IncrementalSV, SV 45,000,000
Present Worth C/F @ MARR
Incremental i*
Decision

PWNetCF
-/ = -P + A(P/A, i*, 5) + SV(P/F, i*, 5) = 0
For i = 12%  (P/A, 12, 5) = 3.6048 (P/F, 12, 5) = 0.5674
For i = 10%  (P/A, 10, 5) = 3.7908 (P/F, 10, 5) = 0.6209
For i = 15%  (P/A, 15, 5) = 3.3522 (P/F, 15, 5) = 0.4972

12 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Solution
Y X Z
comparison “do nothing” to Y Y to X Y to Z
Incremental cost, P -540,000,000 -110,000,000 -180,000,000
Incremental C/F, A 195,000,000 2,500,000 32,500,000
IncrementalSV, SV 45,000,000 7,000,000 157,000,000
Present Worth C/F @ MARR ? ? ?
Incremental i* > 12% < 12% > 12%
Decision Select Y Retain Y Select Z

PWNetCF
-/ = -P + A(P/A, i*, 5) + SV(P/F, i*, 5) = 0
For i = 12%  (P/A, 12, 5) = 3.6048 (P/F, 12, 5) = 0.5674
For i = 10%  (P/A, 10, 5) = 3.7908 (P/F, 10, 5) = 0.6209
For i = 15%  (P/A, 15, 5) = 3.3522 (P/F, 15, 5) = 0.4972

13 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Homework #7
 A ready-mix concrete producer is considering to install a new
mixer system:
Operating characteristics System A System B System C
 Installed cost ($) 2,250,000 2,950,000 2,750,000
 Annual Operating cost ($) 320,000 495,000 401,500
 Annual production (cm) 10,500 21,200 19,900


Unit price ($/cm) 122.50 122.50 122.50
Overhaul cost ($/ 2 years) 220,000 245,000 295,000

Salvage value ($) 221,500 308,000 367,500

Useful life (year) 4 6 6


 a) develop net cash flow tabulation

 b) if the company has set MARR at 12%, which system
should be installed?
 c) if all alternatives are to use MARR, will you
recommend otherwise?
14 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
