Contemporary Engineering Economics, 4 th edition, © 2007 Choice of MARR Lecture No. 62 Chapter 15 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 Review – What is MARR? MARR – Minimum Attractive rate of Return: The required return necessary to make a capital budgeting project such as building a new factory worthwhile (profitable).

Contemporary Engineering Economics, 4 th edition, © 2007 Choice of MARR - Overview  Choice of MARR when Project Financing is Known: Use i e as your MARR.  Choice of MARR when Project Financing is Unknown: Use k as your MARR  Choice of MARR under Capital Rationing: It depends on the lending and borrowing opportunities

Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.8 Choice of MARR when Project Financing is Known To calculate the net present worth of the project, use the cost of equity (i e ) as the discount rate. Explicit accounts for debt flows

Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.9 Choice of MARR when Project Financing is Unknown Without explicitly treating the debt flows, make a tax adjustment to the discount rate, using the weighted cost of capital k.

Contemporary Engineering Economics, 4 th edition, © 2007 Choice of MARR under Capital Rationing

Contemporary Engineering Economics, 4 th edition, © 2007 Example Determining an Appropriate MARR as a Function of the Budget Project Cash Flow IRR AOAO A1 1-$10,000$12,00020% 2-10,00011, ,00011, ,00010, ,00010, ,00010,4004 Borrowing rate (k) = 10% Lending rate (l) = 6%

Contemporary Engineering Economics, 4 th edition, © 2007 An Investment Opportunity Schedule Ranking Alternatives by the ROR

Contemporary Engineering Economics, 4 th edition, © 2007 MARR as a Function of Budget Available Budget Project Selected Correct MARR to Use $40,0001,2,3, and 48% $60,0001,2,3, 4 and 5 MARR = l = 6% $01 and 2MARR = k = 10% k = 10% l = 6%

Contemporary Engineering Economics, 4 th edition, © 2007 A Choice of MARR under Capital Rationing

Contemporary Engineering Economics, 4 th edition, © 2007 Summary  The selection of an appropriate MARR depends generally upon the cost of capital—the rate the firm must pay to various sources for the use of capital.  1. The cost of equity (i e ) is used when debt-financing methods and repayment schedules are known explicitly.  2. The cost of capital (k) is used when exact financing methods are unknown, but a firm keeps it capital structure on target. In this situation, a project’s after-tax cash flows contain no debt cash flows such as principal and interest payment