Capital Budgeting Decisions Lecture No. 63 Chapter 15 Contemporary Engineering Economics Copyright © 2006 Contemporary Engineering Economics, 4th edition, © 2007

Example 15.11 Four Energy Saving Projects under Budget Constraints (Budget Limit = $250,000) Investment Annual O&M Cost Annual Savings (Energy) Annual Savings (Dollars) IRR 1 $46,800 $1,200 151,000 kWh $11,778 15.43% 2 104,850 1,050 513,077 kWh 40,020 33.48% 3 135,480 1,350 6,700,000 CF 32,493 15.95% 4 94,230 942 385,962 kWh 30,105 34.40% Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Marginal Cost of Capital Schedule (MCC) and Investment Opportunity Schedule (OSC) Contemporary Engineering Economics, 4th edition, © 2007

Mutually Exclusive Decision Alternatives (Example 15.11) j Alternative Required Budget Combined Annual Savings 1 2 A1 $(46,800 $10,578 3 A2 (104,850) 38,970 4 A3 (135,480) 31,143 5 A4 (94,230) 35,691 6 A4, A1 (141,030) 46,269 7 A2, A1 (151,650) 49,548 8 A3, A1 (182,280) 41,721 9 A4, A2 (199,080) 74,661 10 A4, A3 (229,710) 66,834 11 A2, A3 (240,330) 70,113 12 A4, A2, A1 (245,880) 85,239 13 A4, A3, A1 (276,510) 77,412 14 A2, A3, A1 (287,130) 80,691 15 A4, A2, A3 (334,560) 105,804 16 A4, A2, A3, A1 (381,360) 116,382 Best Alt.12 Infeasible alternatives Contemporary Engineering Economics, 4th edition, © 2007

Optimal Capital Budget Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 Summary Under conditions of capital rationing, the selection of MARR is more difficult, but generally the following possibilities exist: Conditions MARR A firm borrows some capital from lending institutions at the borrowing rate, k, and some from its investment pool at the lending rate, l. l <MARR< k A firm borrows all capital from lending institutions at the borrowing rate, k. MARR = k A firm borrows all capital from its investment pool at the lending rate, l. MARR = l Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 The cost of capital used in the capital budgeting process is determined at the intersection of the IOS and MCC schedules. If the cost of capital at the intersection is used, then the firm will make correct accept/reject decisions, and its level of financing and investment will be optimal. This view assumes that the firm can invest and borrow at the rate where the two curves intersect. Contemporary Engineering Economics, 4th edition, © 2007

Contemporary Engineering Economics, 4th edition, © 2007 If a strict budget is placed in a capital budgeting problem and no projects can be taken in part, all feasible investment decision scenarios need to be enumerated. Depending upon each investment scenario, the cost of capital will also likely change. Our task is to find the best investment scenario in light of a changing cost of capital environment. As the number of projects to consider increases, we may eventually resort to a more advanced technique, such as a mathematical programming procedure. Contemporary Engineering Economics, 4th edition, © 2007