Selection of a Minimum Attractive Rate of Return Click here for Streaming Audio To Accompany Presentation (optional) Click here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR Cal Poly Pomona - SA162 EGR The Big Picture Framework: Accounting & Breakeven Analysis “Time-value of money” concepts - Ch. 3, 4 Analysis methods –Ch. 5 - Present Worth –Ch. 6 - Annual Worth –Ch. 7,7A,8 - Rate of Return (incremental analysis) –Ch. 9 - Benefit Cost Ratio & other methods Refining the analysis –Ch. 10, 11 - Depreciation & Taxes –Ch Replacement Analysis –Selection of the MARR

EGR Cal Poly Pomona - SA163 Selecting a MARR MARR is generally the maximum of the: –Cost of borrowed money –Cost of capital –Opportunity cost

EGR Cal Poly Pomona - SA164 Sources of Capital Money generated from the operation of the firm (retained profits and cash flow generated from depreciation). External sources of funds: –Short term borrowing - banks (generally unsecured). –Long term borrowing - banks, insurance companies, pension funds, bonds (secured). –Permanent - sale of company stock.

EGR Cal Poly Pomona - SA165 Cost of Funds Cost of capital is the after tax weighted ROR of borrowed funds from all sources.

EGR Cal Poly Pomona - SA166 Investment Opportunities There are many investment opportunities in an active firm and often limited capital. Opportunity cost is the ROR of the best opportunity foregone.

EGR Cal Poly Pomona - SA167 Adjusting MARR to Account for Risk and Uncertainty Increase MARR to avoid marginal projects. Assess the projects using techniques other than economic analysis. Additionally, MARR might be adjusted to reflect imminent inflation.

EGR Cal Poly Pomona - SA168 Selecting a MARR MARR is generally the maximum of the: –Cost of borrowed money –Cost of capital –Opportunity cost If a project we are considering does not generate a greater return than these would cost, then we should put our money into these rather than the project.

EGR Cal Poly Pomona - SA169 Representative Values of MARR Used in Industry 12 to 15% After-tax Payback with a variable life Stable Adequate funding One year payback = 60 % ROR One year payback = 60 % ROR Struggling Limited funds Large projectSmall projectGroup In addition to these two factors,many other factors also affect interest rates: a public vs. a private organization, debt/equity position, risk posture, etc.