Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-1 Developed By: Dr. Don Smith, P.E. Department of Industrial Engineering Texas A&M University College Station, Texas Executive Summary Version Chapter 10 Making Choices: The Method, MARR, and Multiple Attributes

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-2 LEARNING OBJECTIVES 1.Choose a Method 2.Cost of capital and MARR 3.WACC – Weighted Average Cost of Capital 4.Cost of debt capital 5.Cost of equity capital 6.High D-E mixes 7.Multiple attributes 8.Weighted attribute methods

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-3 Sct 10.1 Comparing Mutually Exclusive Alternatives by Different Evaluation Methods  Different problem types lend themselves to different engineering economy methods  Different information is available from different evaluation methods  Primary criteria for what method to apply  Speed  Ease of performing the analysis  See Tables 10-1 & 10-2 for a concise summary

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-4 Evaluation Times  Equal lives of the alternatives  PW, AW, FW  LCM of lives  PW approach  Specified study period  Normally exercised in industry  Infinity (capitalized cost)

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-5 Decision Guidelines  Select the alternative with:  Numerically largest  PW, FW, or AW value  For ROR and B/C  Apply the incremental analysis approach

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-6 Sct 10.2 MARR Relative to the Cost of Capital  Establishing the MARR within the enterprise  Requires:  Cost of equity capital (cost of corporate funds)  Cost of retained earnings included here  Cost of debt capital (cost of borrowed funds)  Debt Capital  $$ acquired from borrowing outside of the firm  Equity Capital  $$ acquired from the owners and retained earnings

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-7 Cost of Capital and the MARR  Established MARR is the sum of: (expressed as a % cost)  Cost of capital +  Expected return +  Risk factor  MARR will vary from firm to firm and from project to project Cost of capital (%) CC Min. MARR Expected return (%) ER CC + x% = ER Established MARR Risk factor added (R%) ER + R%

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-8 Factors Impacting the MARR  Perceived project risk  Higher the risk – higher the MARR for that project  Investment opportunity  Expansion opportunity – may set a lower MARR  Maintain flexibility  Tax structure  Higher tax rate – higher MARR  Federal reserve monetary policy – interest rates  Limited capital  Tighter constraints on capital – higher MARR  Market rates of other firms  Competitors alter their MARR - the firm could follow suit

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 10-9 Sct 10.3 Debt-Equity Mix and WACC  D/E ratio (Debt to Equity mix)  Ex.: DE = {40% from debt, 60% from equity}  Weighted Average Cost of Capital (WACC)  WACC = (equity fraction)(cost of equity capital) + (debt fraction)(cost of debt capital)  Both ‘costs’ are expressed as a percentage cost  Example: WACC = 0.6(4%) + 0.6(9%) = 7.8%  A variety of “models” exist that will approximate the WACC for a given firm

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved WACC: Example 10.3 Source of CapitalAmount ($)Cost (%) Common Stock$5 million13.7% Retained Earnings $2 million8.9% Debt from bonds$3 million7.5% CS = 50%; RE = 20%; Bonds = 30% WACC = (0.50)(13.7) + (0.20)(8.9) + (0.30)(7.5) = 10.88% This firm’s MARR must be > 10.88% Sum: $10 million

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Tax Implications (detailed in Chapter 17)  WACC values are computed:  Before-tax basis  After-tax basis  After-tax WACC = (Before Tax WACC)(1- T e )  Where T e represents the effective tax rate composed of: o Federal rate o State rate o Local rate(s)

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Sct 10.4 Determining Cost of Debt Capital  Debt financing  Loans (borrowing)  $ borrowed from banks  $ borrowed from Insurance companies, etc  Issuance of bonds (borrowing)  Interest on loans and bonds are tax deductible in the US  Bonds are sold (floated) within a bond market by investment bankers on behalf of the firm  Subject to extensive state and federal regulations  Interest payments from the firm to the lenders is tax deductible – important cost consideration

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Tax Savings from Debt Financing  The cost of financing by debt is lower than the actual interest rate charged because of the tax deductibility of the interest payments  Assume T e = the effective tax rate (%)  Tax Savings = ($ expenses)( T e )  Net Cash Flow = {$ expenses - $ tax savings}  NCF = expenses (1 – T e )  See Example 10.4

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Example of Tax Deductibility Impact on Cost of Debt Capital  Assume a loan has a 10% interest rate charged to the borrower  The effective tax rate is 30%  The after-tax cost of borrowing at 10% is (0.10)(1 – 0.30) = (0.10)(0.70) = 0.07 or 7%  Observations  Due to tax deductibility the effective cost is 7% after tax  Higher tax rates result in lower after-tax borrowing rates

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Sct 10.5 Determination of the Cost of Equity Capital and the MARR  Sources of equity capital 1. Sale of preferred stock (PS) 2. Sale of common stock (CS) 3. Use of retained earnings (RE)  RE = past profits retained within the firm  This money belongs to the owners of the firm  Sale of new stock is handled by investment bankers and brokerage firms – highly regulated – charge the firm for these sales

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Types of Stock  Preferred Stock  A form of ownership  Pays a stated dividend per share periodically  Generally a conservative type of stock  Common Stock  A form of ownership  Carries more risk than preferred  No guarantee of dividends to be paid

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Cost of Equity Capital  Cost of equity capital generally applies some form of a dividend growth model or valuation model  Basic model  “g” is the estimated annual increase in returns to the shareholders

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Capital Asset Pricing Model -- CAPM  R e for equity capital is specified by  R e = risk-free return + premium above risk-free return  R e = R f +  (R m – R f )   = volatility of firm’s common stock relative to other stocks o  = 1 is the norm  R m = return on stocks is a defined market portfolio as measured by a prescribed index  R f = quoted US Treasury Bill rate (considered a safe investment)  (R m – R f ) = premium paid above the safe or “risk-free” rate  See Example 10.6

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Sct 10.6 Effect of Debt-Equity Mix on Investment Risk  D-E mix (Review Section 10.3)  As the proportion of debt increasesDue to t the calculated cost of capital tends to decrease  Tax advantage of deducting interest  But…..leverage offered by larger percentage of debt capital increases the risks of funding future projects within the company  Too much debt is a “bad thing”  Objective – strive for a balance between debt and equity funding

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Too Much Debt…..  Use of larger percentages of debt capital increases the risk that is assumed by  Investors (owners) and  Lenders  Over time, investor confidence in the firm may diminish and the value of the stock could well decline  Difficult to attract new investment funds  Lenders will charge higher and higher interest rates to hedge the risk

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Sct 10.7 Multiple Attribute Analysis: Identification and Importance of Each Attribute  Refer back to Chapter 1 and  7-steps in Figure 10-5  Up to now we have focused on one attribute of a decision making problem  Economic attribute!  Complex problems possess more than one attribute  Multiple attribute analysis is often required  Quantitative attributes  Subjective attributes

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Identification of Key Attributes  Must ID the key attributes  Comparison  Input from experts  Surveys  Group discussion  Delphi methods  Tabulate and then agree on the critical mix of subjective and objective attributes

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Importance of Each Attribute  Determine the extent of importance of each attribute  Implies some form of weighting – w i  Given m attributes we want: Value ratings V i j Tabular format of attributes vs. alternatives Weights for each attribute

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Weighting Methodologies  Equal Weighting  All defined attributes are assigned equal weights  Default model  May or may not be appropriate  Rank Order  m attributes are ranked in order of increasing importance (1 = least important; 2, 3, ….)  Weighted Rank Order  m attributes ranked in order of importance and apply:

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Value Rating of Attributes  Each alternative is assigned a value rating – V ij for each attribute i  Can apply a scale of  Can apply a Likert Scale  4-5 graduations (prefer an even number of choices)e.g. o Very Poor o Poor o Good o Very good  See Table 10.4

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Sct 10.8 Evaluation Measure for Multiple Attributes  Weighted Attribute Method  Selection guideline  Choose the alternative with the largest R j value  Assumes increasing weights mean more important attributes  Increasing V ij mean better performance for a given alternative  See Example 10.10

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Chapter Summary  Best methods for economic evaluation  PW and AW at the stated MARR  Public projects  Use the B/C ratio  The interest rate used is based upon the cost of capital, mix between equity and debt, and risk levels  Multiple attributes incorporate more than objective measures and permit the incorporation of criteria that is not totally economic based

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Chapter 10 End of Set